The U.S. Supreme Court is set to hear oral argument in Polar Tankers, Inc. v. City of Valdez, 182 P.3d 614 (Alaska 2008), cert. granted, 129 S. Ct. 762 (Dec. 12, 2008) (No. 08-310) on April 1, 2009. As summarized below, issues in Polar Tankers may have significant implications regarding the emerging use of the “throwout rule” for corporate net income tax purposes.
We next briefly discuss a recent case from the California Court of Appeals, Abbott Labs. v. Franchise Tax Bd., No. B204210 (Cal. Ct. App. Mar. 20, 2009), where the court addressed severability and associated remedy issues raised by the invalidation of the state’s unconstitutional dividends received deduction.
“At Sea” or “Not At Sea” … That Is the Question
No fooling, on April 1, 2009, the Supreme Court will consider the validity of the City of Valdez’s ad valorem property tax that applies to large oceangoing vessels that use Valdez’s docking facilities. Polar Tankers alleges that Valdez’s apportionment formula, which is based on the number of days in Valdez as compared to the number of days in all ports and therefore includes the value of the Polar Tankers’ vessel for periods it is outside any jurisdiction (i.e., when it is at sea), violates the U.S. Constitution’s Tonnage, Commerce, and Due Process Clauses.
Like the rule used by Valdez, several states use apportionment rules that incorporate a “throwout rule,” which “throws out” values that are associated with geographically identifiable locations where the taxpayer is not taxable, and consequently, subjects taxpayers to taxation on values (or income) located outside of the state. A decision in this case addressing the constitutionality of the Valdez throwout rule may influence the determination of whether other throwout apportionment formulas are constitutional.
SUTHERLAND OBSERVATION: While it is possible that the Court may limit its holding to the application of the Tonnage Clause, a decision that the Valdez port-days formula violates the Commerce and/or Due Process Clauses could serve to dissuade states from adopting it for corporate net income tax purposes.
Abbott Labs—“No DRD For You”
In an opinion issued on March 20, 2009, which is not officially published in California and therefore not citable as precedent there, the California Court of Appeal upheld the California Franchise Board’s complete denial of a taxpayer’s dividends received deduction taken under a statute previously rendered unconstitutional. Abbott Labs. v. Franchise Tax Bd., No. B204210 (Cal. Ct. App. Mar. 20, 2009). The Court of Appeal found that the statute, which had previously been invalidated on constitutional grounds, could not be reformed, leaving taxpayers with no statutory dividends received deduction.
In Farmers Bros. Co. v. Franchise Tax Bd., 108 Cal. App. 4th 976 (2003), cert. denied, 540 U.S. 1178 (2004), the same Court of Appeal held that California Revenue and Taxation Code § 24402 discriminated against interstate commerce in violation of the Commerce Clause of the U.S. Constitution by providing a dividends received deduction restricted to dividends paid from income subject to California tax and disallowing a similar deduction for dividends received from income not subject to California tax.
In Abbott Labs, the court affirmed the Franchise Tax Board’s denial of the dividends received deduction to Abbott, holding that § 24402 was unconstitutional in its entirety and could not be judicially reformed. Despite the broad flexibility allowed to state courts to fashion remedies for unconstitutional taxes under McKesson Corp. v. Div. of Alcoholic Beverages & Tobacco, 496 U.S. 18 (1990) as a matter of federal constitutional law, the Court of Appeal stated that it had two options as a matter of state law when fashioning a remedy with regard to the unconstitutional dividends received deduction statute: (1) allow all payee-corporations to take the deduction, or (2) allow no payee-corporations to take the deduction. In rejecting the former option, for which the taxpayer contended, the Court of Appeal reasoned that rewriting or reforming § 24402 to eliminate its constitutionally offensive restriction to dividends from previously taxed income would amount to tax legislation and would be inconsistent with the legislature’s original intent in enacting the provision, namely, to prevent double taxation. Accordingly, the Court held that the proper remedy was to invalidate the statute in its entirety, thus denying a dividends received deduction with respect to all dividends, not simply dividends paid from income previously subject to tax in California. The Court of Appeal observed that it was not its place, but rather the legislature’s, to resolve the striking disparity between what it perceived to be its two options (i.e., “all or nothing” dividends received deduction).
SUTHERLAND OBSERVATION: The Court of Appeals holding in Abbott Labs provides little disincentive for a state to enact an unconstitutional statute. Allowing states to adopt discriminatory tax regimes, and thereafter retain the proceeds generated by the discriminatory tax upon its judicial invalidation, is inequitable. Cf., Westinghouse Elec. Corp. v. Tully, 466 U.S. 388 (1984), remanded to Westinghouse Elec. Corp. v. Tully, 63 N.Y.2d 191, 470 N.E.2d 853 (1984); Comptroller of the Treasury v. Armco, Inc., 70 Md. App. 403, 521 A.2d 785 (Ct. Spec. App. 1987). Further, it is notable that taxpayers subject to the discriminatory California dividend received deduction have not received any “meaningful backward-looking relief.” Doing so would require California to allow taxpayers to claim the dividend received deduction or to prevent all taxpayers from claiming the dividend received deduction. California has not done either. The alleged failure to provide “meaningful backward looking relief” has given rise to considerable amount of post-McKesson litigation. See, e.g., South Cent. Bell Tel. Co. v. State, 789 So.2d 133 (Ala. 1999), remanded to 789 So.2d 147 (Ala. 2000); Ventas Fin. I, LLC v. Franchise Tax Bd., 81 Cal. Rptr. 3d 823 (Cal. Ct. App. 2008).