Hunt-Wesson v. Franchise Tax Bd. California

• Citation: 145 L.Ed.2d 974,120 S.Ct. 1022,528 U.S. 458
• Decision Date: 22 February 2000
• Docket Number: 982043
• Parties: Syllabus NOTE: Where it is feasible, a syllabus (headnote) will be released, as is being done in connection with this case, at the time the opinion is issued. The syllabus constitutes no part of the opinion of the Court but has been prepared by the Reporter of Decisions for the convenience of the reader. See United States v. Detroit Timber & Lumber Co., 200 U.S. 321, 337. SUPREME COURT OF THE UNITED STATESv. FRANCHISE TAX BOARD OF CALIFORNIA CERTIORARI TO THE COURT OF APPEAL OF CALIFORNIA, FIRST APPELLATE DISTRICT2043
• Court: United States Supreme Court

528 U.S. 458

120 S.Ct. 1022

145 L.Ed.2d 974

Syllabus

NOTE: Where it is feasible, a syllabus (headnote) will be released, as is being done in connection with this case, at the time the opinion is issued. The syllabus constitutes no part of the opinion of the Court but has been prepared by the Reporter of Decisions for the convenience of the reader. See United States v. Detroit Timber & Lumber Co., 200 U.S. 321, 337.

SUPREME COURT OF THE UNITED STATES

HUNT-WESSON, INC.

v.

FRANCHISE TAX BOARD OF CALIFORNIA

CERTIORARI TO THE COURT OF APPEAL OF CALIFORNIA,

FIRST APPELLATE DISTRICT

No. 98 2043.

Argued January 12, 2000.

Decided February 22, 2000.

A State may tax a proportionate share of the "unitary" income of a nondomiciliary corporation that carries out a particular business both inside and outside that State, Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768, 772, but may not tax "nonunitary" income received by a nondomiciliary corporation from an "unrelated business activity" which constitutes a "discrete business enterprise," e.g., id., at 773. California's "unitary business" income-calculation system for determining that State's taxable share of a multistate corporation's business income authorizes a deduction for interest expense, but permits (with one adjustment) use of that deduction only to the extent that the amount exceeds certain out-of-state income arising from the unrelated business activity of a discrete business enterprise, i.e., nonunitary income that the State could not otherwise tax under this Court's decisions. Petitioner Hunt-Wesson, Inc., is a successor in interest to a nondomiciliary of California that incurred interest expense during the years at issue. California disallowed the deduction for that expense insofar as the nondomiciliary corporation had received relevant nonunitary dividend and interest income. Hunt-Wesson challenged the disallowance's constitutional validity. The State Court of Appeal found it constitutional, and the State Supreme Court denied review.

Held: Because California's interest deduction offset provision is not a reasonable allocation of expense deductions to the income that the expense generates, it constitutes impermissible taxation of income outside the State's jurisdictional reach in violation of the Federal Constitution's Due Process and Commerce Clauses. 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." Container Corp. of America v. Franchise Tax Bd., 463 U.S. 159, 165 166. Although California's statute does not directly impose a tax on nonunitary income, it measures the amount of additional unitary income that becomes subject to its taxation (through reducing the deduction) by precisely the amount of nonunitary income that the taxpayer has received. Thus, that which California calls a deduction limitation would seem, in fact, to be an impermissible tax. National Life Ins. Co. v. United States, 277 U.S. 508. If California could show that its deduction limit actually reflected the portion of the expense properly related to nonunitary income, however, the limit would not, in fact, be a tax on that income, but merely a proper allocation of the deduction. See Denman v. Slayton, 282 U.S. 514. The state statute, however, pushes this proportional allocation concept past reasonable bounds. In effect, it assumes that a corporation that borrows any money at all has really borrowed that money to "purchase or carry," cf. 26 U.S.C. § 265(a)(2), its nonunitary investments (as long as the corporation has such investments), even if the corporation has put no money at all into nonunitary business that year. No other taxing jurisdiction has taken so absolute an approach. Rules used by the Federal Government and many States that utilize a ratio of assets and gross income to allocate a corporation's total interest expense between domestic and foreign source income recognize that borrowing, even if supposedly undertaken for the unitary business, may also support nonunitary income generation. However, unlike the California rule, ratio-based rules do not assume that all borrowing first supports nonunitary investment. Rather, they allocate each borrowing between the two types of income. Over time, it is reasonable to expect that the ratios used will reflect approximately the amount of borrowing that firms have actually devoted to generating each type of income. Conversely, it is simply not reasonable to expect that a rule that attributes all borrowing first to nonunitary investment will accurately reflect the amount of borrowing that has actually been devoted to generating each type of income. Pp. 5 9.

Reversed and remanded.

Opinion of the Court

NOTICE: This opinion is subject to formal revision before publication in the preliminary print of the United States Reports. Readers are requested to notify the Reporter of Decisions, Supreme Court of the United States, Washington, D. C. 20543, of any typographical or other formal errors, in order that corrections may be made before the preliminary print goes to press.

SUPREME COURT OF THE UNITED STATES.

No. 98 2043.

HUNT-WESSON, INC., PETITIONER

v.

FRANCHISE TAX BOARD OF CALIFORNIA

ON WRIT OF CERTIORARI TO THE COURT OF APPEAL OF

CALIFORNIA, FIRST APPELLATE DISTRICT

February 22, 2000

Justice Breyer delivered the opinion of the Court.

A State may tax a proportionate share of the income of a nondomiciliary corporation that carries out a particular business both inside and outside that State. Allied-Signal, Inc. v. Director, Div. of Taxation, 504 U.S. 768, 772 (1992). The State, however, may not tax income received by a corporation from an " ' "unrelated business activity" ' which constitutes a ' "discrete business enterprise." ' " Id., at 773 (quoting Exxon Corp. v. Department of Revenue of Wis., 447 U.S. 207, 224 (1980), in turn quoting Mobil Oil Corp. v. Commissioner of Taxes of Vt., 445 U.S. 425, 442, 439 (1980)). California's rules for taxing its share of a multistate corporation's income authorize a deduction for interest expense. But they permit (with one adjustment) use of that deduction only to the extent that the amount exceeds certain out-of-state income arising from the unrelated business activity of a discrete business enterprise, i.e., income that the State could not otherwise tax. We must decide whether those rules violate the Constitution's Due Process and Commerce Clauses. We conclude that they do.

I

The legal issue is less complicated than may first appear, as examples will help to show. California, like many other States, uses what is called a "unitary business" income-calculation system for determining its taxable share of a multistate corporation's business income. In effect, that system first determines the corporation's total income from its nationwide business. During the years at issue, it then averaged three ratios those of the firm's California property, payroll, and sales to total property, payroll, and sales to make a combined ratio. Cal. Rev. & Tax Code Ann. §§25128, 25129, 25132, 25134 (West 1979). Finally, it multiplies total income by the combined ratio. The result is "California's share," to which California then applies its corporate income tax. If, for example, an Illinois tin can manufacturer, doing business in California and elsewhere, earns $10 million from its total nationwide tin can sales, and if California's formula determines that the manufacturer does 10% of its business in California, then California will impose its income tax upon 10% of the corporation's tin can income, $1 million.

The income of which California taxes a percentage is constitutionally limited to a corporation's "unitary" income. Unitary income normally includes all income from a corporation's business activities, but excludes income that "derive[s] from unrelated business activity which constitutes a discrete business enterprise," Allied-Signal, 504 U.S., at 773 (internal quotation marks omitted). As we have said, this latter "nonunitary" income normally is not taxable by any State except the corporation's State of domicile (and the states in which the "discrete enterprise" carries out its business). Ibid.

Any income tax system must have rules for determining the amount of net income to be taxed. California's system, like others, basically does so by asking the corporation to add up its gross income and then deduct costs. One of the costs that California permits the corporation to deduct is interest expense. The statutory language that authorizes that deduction the language here at issue contains an important limitation. It says that the amount of "interest deductible" shall be the amount by which "interest expense exceeds interest and dividend income . . . not subject to allocation by formula," i.e., the amount by which the interest expense exceeds the interest and dividends that the nondomiciliary corporation has received from nonunitary business or investment. Cal. Rev. & Tax Code Ann. §24344 (West 1979) (emphasis added); Appendix, infra. Suppose the Illinois tin can manufacturer has interest expense of $150,000; and suppose it receives $100,000 in dividend income from a nonunitary New Zealand sheep-farming subsidiary. California's rule authorizes an interest deduction, not of $150,000, but of $50,000, for the deduction is allowed only insofar as the interest expense "exceeds" this other unrelated income.

Other language in the statute makes the matter a little more complex. One part makes clear that, irrespective of nonunitary income, the corporation may use the deduction against unitary interest income that it earns. §24344. This means that if the Illinois tin can manufacturer has earned $100,000 from tin can related interest, say...