California interest-offset rule is discriminatory and should be struck down, TEI urges Supreme Court.

• Position: Friend-of-the-court brief filed by Tax Executives Institute with the U.S. Supreme Court filed July 22, 1999 reprinted in this issue, p. 357 - Brief Article

A California statute that requires out-of-state corporations to offset their legitimate interest expense against non-taxable income violates the United States Constitution, Tax Executives Institute told the Supreme Court of the United States in a "friend of the court" brief filed on July 22. In Hunt-Wesson, Inc. v. Franchise Tax Board, TEI urged the Court to review the case and strike down California's interest-offset rule for violation of the Constitution's Commerce Clause and Due Process Clause.

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 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 TEI believes is unconstitutional.

In this case, the trial court concluded that section 24344 violates the Due Process and Commerce Clauses of the Constitution. This 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 Telephone & Telegraph Co. v. Franchise Tax Board. TEI pointed out, however, that subsequent decisions of the U.S. Supreme Court -- such as the South Central Bell Telephone case decided earlier this year -- "unequivocally demonstrate that the State's 1972 decision cannot stand."

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...