The questionable constitutionality of the California DRD and interest offset rules.

• Author: Rosen, Jay M.
• Position: Dividends-received deductions

The California Bank and Corporation Tax Law currently provides dividends-received deductions (DRDs) modeled on those in Sec. 243 of the Internal Revenue Code. The California DRDs, however, are limited to dividends paid from earnings and profits (E&P) generated from California sources. This limitation creates a bias in favor of investing in California-based companies. In light of several U.S. Supreme Court decisions, such a geographically based DRD appears to violate the U.S. Constitution.

In addition, the California Bank and Corporation Tax Law contains another provision that tends to discriminate against non-California-source dividends. This second provision, known as the "interest offset rule," effectively disallows the deduction of interest expense in an amount equal to the nonbusiness income of corporations not headquartered in California. Since interest expense would only be offset against non-California-source dividends, this provision also creates a bias in favor of investing in California corporations. A California Superior Court recently found the interest offset rule to violate the Due Process, Commerce and Equal Protection Clauses of the U.S. Constitution.(1)

Treatment of California-Source and Non-California-Source Dividends

California Rev. & Tax. Code section 24402 provides that a corporation may deduct the percentage of a dividend received from another corporation if the dividend is paid from income that the payer corporation "included in the measure" of its California franchise tax or corporation income tax. The amount deductible depends on (1) the percentage of the recipient's ownership in the payer corporation and (2) the percentage of the payer's income derived from California sources. If the recipient owns more than 50% of the payer (by vote or value), the recipient may receive up to a 100% deduction; if it owns from 20% to 50% of the payer (by vote or value), the recipient may receive up to an 80% deduction; and if it owns less than 20% of the payer (by vote or value), the recipient may receive up to a 70% deduction (Rev. & Tax. Code section 24402(b)).

The second limitation restricts the DRD by the payer's activity in California. The percentage deductible equals the income of the payer corporation included in California taxable income over the payer corporation's total income (Rev. & Tax. Code section 24402; Regs. section 24402). The following example illustrates the application of both restrictions.

Example 1: Recipient corporation C owns 40% of the payer; 70% of the payer's income is from California sources. C can exclude 56% of the dividend: The 40% ownership limits the deduction to 80% of the dividend, and the payer's activities in California further limit the deduction to 56% (70% of the 80%). If C owned 15% of the payer, the amount deductible would be 49%: 70% deduction based on ownership, further reduced by 70% due to the payer's activities in California.

The DRD issue would not affect dividends received from corporations that are members of the same unitary business group as the dividend recipient. These intercompany dividends are fully excluded from the recipient's taxable income under Rev. & Tax. Code: section 25106, without regard to their geographic source. Often, when a taxpayer has more than 50% ownership of the voting stock of another entity, a unitary business relationship exists. However, because a unitary relationship requires the presence of other factors as well as ownership,(2) the DRD can easily apply to dividends received from a subsidiary when those other factors are not present.(3) Furthermore, Rev. & Tax. Code section 24402 provides the only basis for deducting dividends taxable in California received from payers in which the recipient owns 50% or less of the voting stock.

While a dividend recipient not domiciled in California may claim that dividends from nonunitary subsidiaries and minority stockholdings are nonbusiness income allocable entirely outside of California, application of the "interest offset rule" tends to negate such a claim. Under this rule, the dividend recipient is required to allocate its net interest expense (the excess of interest expense over business interest income) against nonbusiness dividend (and interest) income. The allocation of interest expense outside of California is effectively the equivalent of denying that portion of interest expense as a deduction for California tax purposes. The interest offset rule, however, does not apply to dividends from California sources excluded from California taxable income under the DRD provisions (Rev. & Tax. Code section 24344(b)). As a result, only non-California-source dividends are subject to the interest offset rule.

California also has a specific DRD provision for dividends received from insurance companies (Rev. & Tax. Code section 24410).(4) If the recipient corporation is commercially domiciled in California, it may deduct dividends received from a California subsidiary insurance company if the recipient owns at least 80% of each class of the insurance company's stock and the dividends are paid from California-source income. The amount of the insurance company's California-source income equals the dividends received multiplied by the ratio of gross income from California sources to all gross income.(5) A company not commercially domiciled in California is not eligible for the DRD, under Rev. & Tax. Code section 24410. This lack of a DRD tends to be problematic when the dividend is treated as apportionable business income by the California Franchise Tax Board (FTB).(6)

Constitutional Standards

The U.S. Supreme Court has held on numerous occasions that state tax statutes that facially discriminate against interstate and foreign commerce violate the Commerce Clause of the U.S. Constitution.(7) In Kraft General Foods, Inc. v. Iowa Dept. of Rev. and Fin.,(8) the Supreme Court made it clear that a state's favorable tax treatment of dividends based on their geographical source is not allowed.

For the tax years in dispute in Kraft, Iowa adopted the Federal DRD provisions of Sec. 243. Under Sec. 243, dividends from U.S. domestic corporations are eligible for full or partial DRDs, while dividends from foreign corporations paid from E&P not effectively connected with a U.S. trade or business are not eligible for the DRD. To prevent double taxation of the foreign-source dividends at the Federal level, the Internal Revenue Code contains foreign tax credit provisions; the Iowa tax law, however, did not provide for similar credits. The Supreme Court found that the Iowa regime of taxing dividends generated from non-U.S. business activities of foreign corporations discriminated against foreign commerce in violation of the Commerce Clause.

Iowa raised several arguments in its defense. The taxpayer could have avoided taxation of its foreign dividends through use of a holding company incorporated and domiciled in a tax haven state. This holding company would have received the foreign dividends and, in turn, paid a dividend to the taxpayer. Since the holding company's dividend would have been from a U.S. corporation, the taxpayer would have been entitled to a DRD for Iowa tax purposes. The Supreme Court stated that Iowa could not force a taxpayer to...