Remedies for Unapportioned Gross Receipts Taxes

Client Alert

When a tax is determined to be unconstitutional because it is not properly apportioned, is the proper remedy to impose the amount of tax that would have been allowed under a proper apportionment scheme, or is the entire amount of the proposed tax simply stricken? The California Court of Appeal recently addressed this issue involving an unapportioned tax on gross receipts and provided a needed wake-up call to the many California cities that still have defective taxes on their books: they will not be permitted to enforce an unapportioned tax against taxpayers, nor may they unreasonably delay in enacting apportionment guidelines—otherwise they will be barred from collecting even a fair and apportioned tax for past periods. See City of Modesto v. National Med, Inc., 128 Cal. App. 4th 518 (2005). The court thus made it clear that cities must bear the burdens associated with remedying an unconstitutional tax; they may not shift that burden to the taxpayers who have been harmed.


National Med, Inc. ("NMI") was a health maintenance organization headquartered in Modesto, with operations throughout the State of California. During the period at issue in this case—January 1996 through June 2000—the City of Modesto ("City") imposed a business license tax measured by gross receipts on entities engaged in business within the city. Although the United States and California constitutions require that gross receipts taxes be apportioned to prevent taxing the taxpayer’s business activities outside the particular jurisdiction, the City’s ordinance did not contain a provision entitling taxpayers to apportion their gross receipts during the period at issue.

Like many other California cities, the City hired an outside contingency fee auditor to examine its taxpayers’ returns. Provided with the incentive of receiving a percentage of all additional tax revenues it could extract from NMI, it was not surprising when the contingency fee auditor claimed that NMI was not entitled to certain deductions it had taken and thus owed the City additional taxes.

NMI sent the auditor a letter in early 2000 explaining why NMI was entitled to claim the deductions it had taken and informing the auditor that, in any event, the City’s tax was unconstitutional because it lacked an apportionment provision and thus taxed receipts NMI earned outside the city. NMI again raised the constitutional defects of the tax in its hearing before the Finance Director in 2001 and in several letters to the City Council. Nonetheless, the City stubbornly maintained that its credit for taxes paid to other jurisdictions cured this deficiency, and sued NMI to collect these additional taxes.

Despite NMI’s efforts to have the City address the infirmities of its tax, the City aggressively pursued its collection—by denying NMI a hearing before the City Council, alleging in court that NMI violated the California False Claims Act, and demanding a letter of credit that was seven times greater than the amount of tax, interest, and penalties the Finance Director had determined was due. Indeed, the City’s litigation tactics were so outrageous that the trial court later determined that the City had violated NMI’s due process rights and awarded NMI $270,000 in damages and attorneys’ fees in a civil rights action.

The Trial Court’s Decision

In 2002, NMI filed a motion for summary adjudication on the grounds that the California False Claims Act did not apply to the filing of municipal tax returns and the City’s tax was unconstitutional. It was not until this motion was pending that the City finally acknowledged that its tax was unconstitutional and amended its tax code to add an "apportionment" provision. However, the new provision merely called for the establishment of apportionment guidelines and did not contain any specific instructions as to how such an apportionment should be performed. The trial court thus found that the new provision was "nothing more than a promise to adopt specific apportionment language at some unknown future date" and that it did not "provide this Court (or taxpayers) with any guidance as to how NMI’s activities within the City should be measured, or whether that measurement will fairly represent NMI’s activities within Modesto." On this basis, the trial court held that the new apportionment provision did "not solve the constitutional infirmities in the City’s gross receipts tax" and that the tax could not be enforced against NMI.

The Court of Appeal’s Decision

The City appealed the trial court’s decision. The City conceded in its appeal that its prior ordinance was unconstitutional and that apportionment was required. Nevertheless, the City argued that the case should be remanded to the Finance Director to allow the City to calculate and impose upon NMI a properly apportioned tax using guidelines that the City had passed in 2003—one year after it had amended its tax code to provide for the enactment of an apportionment provision, and almost a full year after the trial court ruled that its gross receipts tax was unconstitutional. However, the 2003 guidelines contained several procedural defects, which NMI identified for the court in its opposition brief. Shortly thereafter, the City amended the guidelines yet again, and claimed that the Court of Appeal should consider its new 2004 guidelines when rendering its decision, even though NMI had already completed its briefing in the case.

The Court of Appeal denied the City’s request and held instead that the tax could not be enforced against NMI. Significantly, the court held that the new apportionment provision and guidelines could not be applied retroactively because the City Council did not act promptly, and the period of retroactivity was too long. The court further held that it could not judicially reform the former tax code to apply the apportionment provision and guidelines to the period at issue because doing so would improperly encroach on the legislative function. The court also concluded that the retroactive application of the apportionment provision and guidelines would violate NMI’s due process rights by placing an unfair burden on NMI to produce documentation from up to nine years ago (i.e., 1996-2000), which it previously had not been required to maintain. The court also concluded that the City’s apportionment provision was a substantive amendment to its tax code, and that the amendment could not be applied to the period at issue because the City Council had specified that only procedural amendments to the code should be applied retroactively. The Court of Appeal’s decision became final in June 2005.

Future Implications

The Court of Appeal’s decision is consistent with California and United States Supreme Court precedent holding that taxing authorities may not enforce unapportioned taxes, courts may not reform unconstitutional ordinances unless the intent of the enacting body is clearly articulated, and retroactively imposed taxes must be limited to a very short period of retroactivity and must comply with due process requirements. The Court of Appeal’s decision serves as a valuable reminder of these basic principles and incorporates them into a thoughtful analysis of the issues presented by this case.

From a more practical perspective, the court’s decision also makes it clear that cities will not be permitted to overtax local businesses, requiring them to litigate well-established constitutional issues, and then, once the tax is declared unconstitutional, be allowed to simply impose the tax that should have been charged in the first place. In other words, the Court of Appeal’s decision provides cities with an incentive to comply with the Constitution from the outset, thus encouraging the protection of all taxpayers—even those without the resources or incentive to litigate the issue.

The Court of Appeal’s decision also discourages the "legislate as you litigate" tactics employed by the City in this case. As discussed above, NMI informed the City that its tax was unconstitutional in 2000. Yet, rather than responding to NMI’s legitimate concerns, the City waited until 2002 to amend its tax code, then enacted apportionment guidelines in 2003 and amended those guidelines 2004 – all in direct response to issues raised by NMI during the litigation.

In addition to denying NMI the right to brief issues arising under the 2004 guidelines, the City’s approach effectively created a moving target as to which version of the tax code or guidelines the court should examine and base its decision upon. Had the Court of Appeal permitted this behavior, cities would have no incentive to resolve constitutional infirmities present in their tax code unless and until absolutely necessary, which would lead to unnecessary litigation regarding issues that could have been resolved earlier in the case. The court’s decision to limit the period during which apportionment guidelines may be retroactively applied discourages the use of parallel litigation and legislation tactics, preserves judicial resources, and provides taxpayers with greater certainty.

Charles Moll and Pilar Sansone, as well as Litigation partner Arturo Gonzalez, litigated this case.

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