Hunt-Wesson, Inc. v. Franchise Tax Board of California (02/22/2000)

By: Katie Lewis, Medill News Service

Questions presented

(1) May a state tax constitutionally-exempt income under the guise of denying a deduction for expenses in an amount equal to such income whenthere is no evidence that expenses relate to production of exempt income? (2) Does a state tax violate the Constitution's commerce clause by disallowing an otherwise deductible expense, thereby increasing California taxable income, solely becausea corporation is not domiciled in the state or does not have subsidiaries that engage in taxable in-state activity?

Brief

In the mid 1980s, Beatrice Companies, Inc. was a corporation that operated out of the state of Illinois and owned several other subsidiaries throughout the United States. Beatrice and its subsidiaries conducted business in the state of California, though no part of the corporation was based there.

All branches of Beatrice paid dividends, or portions of their profits, to Beatrice. Because the corporation was based out of Illinois, the dividends were taxed by the state of Illinois. California also tried to tax Beatrices dividends.

Attorneys for Beatrice objected, arguing that the Franchise Tax Board of California discriminated against Beatrice by not allowing the company to receive full deductions that other businesses within California were granted. Essentially, California made up for the taxes it did not receive from Beatrice by reducing the amount of deductions they could receive.

After acquiring Beatrice Company in the mid-1980s, Hunt-Wesson filed suit against the Franchise Tax Board, seeking a refund of $1,523,462 plus interest.

A trial court in California decided in favor of Hunt-Wesson on all counts. It held that California violated the Due Process Clause of the U.S. Constitution by indirectly taxing an out of state business. The court also ruled that California discriminated against Beatrice by refusing to offer the company its full tax refund and thus violated the Commerce and Equal Protection Clauses.

On Dec.11, 1998, the California Court of Appeals reversed. It based its ruling on the 1972 case, Pacific Telephone and Telephone Co. v. Franchise Tax Board. Pacific Telephone, like Hunt-Wesson, was a company that had businesses based in several states throughout the U.S. and conducted business with California. Pacific Telephone was also taxed by the Franchise Board of California in the same manner as Hunt-Wesson. In its 1972 ruling, the California Supreme Court held that California did not violate the statute in question in Pacific Telephone because the state didn't unlawfully tax the company's nontaxable income.

In reviewing Pacific Telephone in relation to Hunt-Wesson, the California Court of Appeals stated that if it were working from a ""clean slate,"" it would rule in favor of the taxpayer, Beatrice. Instead, the court ruled in favor of the Franchise Tax Board of California since it felt the language set forth in Pacific was binding.

The California Supreme Court did not hear this case, but the U.S. Supreme granted certiorari on Sept. 28, 1999.

On Feb. 22, 2000, a unanimous Court reversed and remanded, holding that because California's interest deduction offset provision is not a reasonable allocation of expense deductions to the income that the expense generates, it constitutes an impermissible taxation of income outside the California's jurisdictional reach in violation of the due process and commerce clauses of the Constitution.

States may not tax income arising out of interstate activities--even on a proportional basis--unless there is a ""minimal connection"" or ""nexus"" between such activities and the taxing state, and a ""rational relationship between the income attributed to the state and the intrastate values of the enterprise,"" wrote Justice Stephen Breyer.

Conceding that California's statute does not directly impose a tax on income, the Court still concluded that California measures the amount of additional income that becomes subject to its taxation by precisely the amount of income that the taxpayer has received, thus, making it an impermissible tax.