Brief of Tax Executives Institute, Inc. as amicus curie in support of petitioner.

• Position: California interest-offset taxation

On November 10, 1999, Tax Executives Institute filed the following brief with the Supreme Court of the United States concerning the constitutionality of the State of California's interest-offset rule, pursuant to which a nondomiciliary company's interest deduction is reduced dollar-for-dollar by the amount of dividend income received from non-unitary subsidiaries. The brief was prepared under the aegis of TEI's State and Local Tax Committee, whose chair is Amy J. Eisenstadt of General Electric Company. An earlier TEI brief, successfully urging the Supreme Court to review the lower court decision in Hunt-Wesson, is reprinted in the July-August issue of The Tax Executive.

Interest of Amicus Curiae

Pursuant to Rule 37 of the Rules of the Supreme Court, Tax Executives Institute, Inc. respectfully submits this brief as amicus curiae in support of Petitioner.(1) Tax Executives Institute (hereinafter "TEI" or "the Institute") is a voluntary, nonprofit association of corporate and other business executives, managers, and administrators who are responsible for the tax affairs of their employers. The Institute was organized in 1944 and currently has approximately 5,000 members who represent nearly 2,800 of the leading businesses in the United States and Canada, nearly all of which are engaged in interstate commerce.

The members of the Institute represent a cross-section of the business community in North America. The Institute is dedicated to promoting the uniform and equitable enforcement of the tax laws throughout the Nation, to reducing the costs and burdens of administration and compliance to the benefit of both the government and taxpayers, and to vindicating the due process and Commerce Clause rights of business taxpayers.

Tax Executives Institute's members have a vital interest in this case, which involves the unconstitutional effect of the so-called interest-offset rule in section 24344 of the California Revenue and Taxation Code. Many of the companies represented by TEI are directly and adversely affected by the interest-offset rule, which reduces a company's interest expense deduction for each dollar of dividends received from non-unitary subsidiaries. Even those TEI members whose companies are not doing business in California are, almost without exception, engaged in interstate commerce. Consequently, they benefit from, and are entitled to, the positive business environment ensured by the Commerce Clause and Due Process Clause of the United States Constitution.

Because TEI members and the businesses by which they are employed will be materially affected by the Court's decision in this case, the Institute has a special interest in the outcome of this case.

Summary of Argument

The question presented in this case is whether the State of California's system of taxation for out-of-state companies violates the Commerce Clause and Due Process Clause of the Constitution. It is well settled that a State may not tax value outside its borders. Such taxation is proscribed because the "fundamental purpose of the [Commerce] Clause is to assure that there be free trade among the several States," Boston Stock Exchange v. State Tax Comm'n, 429 U.S. 318, 335 (1977), and because extraterritorial taxation offends fundamental notions of due process and constitutes an "unreasonable clog on the mobility of commerce," Baldwin v. G.A.F. Seelig, Inc., 294 U.S. 511, 527 (1935).

Like many states, California imposes a corporate franchise tax for the privilege of doing business in the State, using an apportionment formula in respect of corporations with income from sources within and without the State. In calculating a taxpayer's net taxable income, business interest expense is generally deducted from business income. Under section 24344 of the California Revenue and Taxation Code, however, taxpayers must offset their business interest expense -- on a dollar-for-dollar basis -- with non-business income not allocable to the State. Thus, out-of-state corporations (such as Petitioner Hunt-Wesson) are compelled to reduce their interest deduction by the amount of their nontaxable income, without regard to whether the interest expense is related to the nontaxable income. It is this statute that is at issue here.

In this case, the trial court concluded that section 24344 violates the Due Process, Commerce, and Equal Protection Clauses of the Constitution. This latter decision was reversed by the Court of Appeal, First Appellate District, largely on the force of the Supreme Court of California's 1972 decision in Pacific Tel. & Tel. Co. v. Franchise Tax Board, 7 Cal. 3d 544 (1972). Subsequent decisions of this Court, however, unequivocally demonstrate that the State's 1972 decision cannot stand. South Central Bell Tel. Co. v. Alabama, 119 S. Ct. 1180 (1999); Fulton Corp. v. Faulkner, 516 U.S. 325 (1996); Oregon Waste Systems, Inc. v. Department of Environmental Quality, 511 U.S. 93 (1994).

In Pacific Telephone, the taxpayer challenged the California interest-offset statute as it applied to nondomiciliary corporations. In reviewing the rule, the California Supreme Court conceded that "when viewed in the light of a domiciliary corporation," the rule "does not deprive the taxpayer of any of its interest deduction, but is merely an attempt to provide how the interest expense shall be allocated as between income from operations and income from investments." 7 Cal. 3d at 551 (emphasis in original). The court also commented that the allocation of interest expense is "very favorable" to the domiciliary corporation. Id. As applied to out-of-state companies, however, the allocation is manifestly not favorable. Hence, on its face, the rule violates the overarching principle of the Commerce and Due Process Clauses that an apportionment formula must, first and foremost, be fair. Container Corp. v. Franchise Tax Board, 463 U.S. 159, 169 (1983).

Commerce Clause jurisprudence has evolved significantly since California's decision in Pacific Telephone. Nowhere has this evolution been more profound than in respect of statutory schemes that facially discriminate against out-of-state commerce. Last term, in South Central Bell, this Court invalidated Alabama's franchise tax as facially discriminatory because it 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 that same ability." 119 S. Ct. at 1185. Five years ago, in Oregon Waste, the Court similarly struck down a surcharge on the disposal of waste generated out of state, holding that the taxing scheme was virtually per se invalid. Id. Accord Fulton Corp., 516 U.S. at 331.

By its very terms, the interest-offset rule at issue here violates the Commerce Clause. As the trial court found, "the offset provisions treat two corporations in an identical business transaction differently based solely on their state of domicile, which difference results in increased taxes for foreign corporations." (App. at 28a-29a.)(2) Under extant Commerce Clause jurisprudence, the California statute must therefore fall.

The law also offends the Due Process Clause, which requires a minimal connection between the interstate activities and the taxing State, as well as a rational relationship between the income attributed to the taxing State and the intrastate value of the corporate business. AlliedSignal, Inc. v. Director, Division of Taxation, 504 U.S. 768, 772-73 (1992) (citations omitted). California does not contend that the non-business income at issue here bears any relation to Petitioner's in-state activities. Rather, the State seeks to tax Petitioner's extraterritorial activities by requiring a dollar- for-dollar offset of constitutionally protected income against interest expense.

Under Allied-Signal, a State may tax dividend income only where the payee and payer of the dividend are engaged in a unitary business or the capital transaction serves an operational -- rather than an investment -- function. 504 U.S. at 787. The dividend income sought to be taxed here bears no relationship to Petitioner's in-state activities and thus California's covert attempt to tax it should be rejected as violative of due process.

Moreover, the State's semantics -- that the interest-offset rule is not a "tax" and therefore the precedents of this Court are not controlling -- cannot change the substance of the statute. It is clear that California could not tax Petitioner's dividend income directly. It is also clear that a State may not, through constitutional alchemy, indirectly tax constitutionally protected income.

In Allied-Signal, the Court validated the "necessary limit on the States' authority to tax value or income that cannot in fairness be attributed to the...