State ex rel. Douglas v. Karnes

• Decision Date: 09 March 1984
• Docket Number: No. 83-241,83-241
• Citation: 216 Neb. 750,346 N.W.2d 231
• Parties: STATE of Nebraska ex rel. Paul L. DOUGLAS, Attorney General of the State of Nebraska, Plaintiff, v. Donna KARNES, Tax Commissioner of the State of Nebraska, Defendant.
• Court: Nebraska Supreme Court

Page 231

346 N.W.2d 231

216 Neb. 750

STATE of Nebraska ex rel. Paul L. DOUGLAS, Attorney General of the State of Nebraska, Plaintiff, v. Donna KARNES, Tax Commissioner of the State of Nebraska, Defendant.

No. 83-241.

Supreme Court of Nebraska.

March 9, 1984.

Syllabus by the Court

Constitutional Law: Taxation. Nebraska's franchise tax, Neb.Rev.Stat. § 77-2734(2) (Cum.Supp.1982), insofar as it is a tax on interest from federal obligations, is a discriminatory tax, contrary to federal law, and, therefore, invalid.

Wright, Rembolt, Milligan & Berger, Lincoln, for defendant.

Paul L. Douglas, Atty. Gen., and Ralph H. Gillan, Lincoln, for plaintiff.

William B. Brandt of Brandt, Horan & Hallstrom, Unadilla, for amicus curiae Nebraska Bankers Ass'n, Inc.

KRIVOSHA, C.J., and BOSLAUGH, WHITE, HASTINGS, CAPORALE, SHANAHAN, and GRANT, JJ.

SHANAHAN, Justice.

As authorized by Neb. Const. art. V, § 2, Neb.Rev.Stat. § 24-204 (Reissue 1979), and Neb.Ct.R. 15 (Rev.1982), Paul L. Douglas, Attorney General of the State of Nebraska (Attorney General), filed an original action in this court against Donna Karnes, Tax Commissioner of the State of Nebraska (Commissioner), for a declaratory judgment that a part of the Nebraska corporate franchise tax, Neb.Rev.Stat. § 77-2734(2) (Cum.Supp.1982), constitutes a discriminatory franchise tax prohibited by federal law [31 U.S.C. § 742 (1976); 31 U.S.C.A. § 3124(a) (1983) ] and is, therefore, an invalid tax.

The Nebraska franchise tax is authorized by § 77-2734(2) (Reissue 1981), a part of the Nebraska Revenue Act of 1967: "[F]or the privilege of exercising its franchise or doing business in this state in a corporate capacity, there is hereby imposed a franchise tax on each corporation ... measured by its entire net income derived from all sources within this state for the taxable year .... [T]he taxpayer's entire net income shall be its federal taxable income derived from sources within this state ... without regard to the modification referred to in section 77-2741 ...." (Emphasis supplied.)

Neb.Rev.Stat. § 77-2741 (Reissue 1981) provides: "Interest and dividends are allocable to this state if the taxpayer's commercial domicile is in this state, subject to the modifications provided by section 77-2716." Reductions regarding tax-exempt interest income are found in Neb.Rev.Stat. § 77-2716(1) (Reissue 1981): "There shall be subtracted from federal taxable income interest or dividends on obligations of the United States ... to the extent includible in gross income for federal income tax purposes but exempt from state income taxes under the laws of the United States; Provided, that the amount subtracted under the provisions of this subsection shall be reduced by any interest on indebtedness incurred to carry the obligations or securities described in this subsection, and by any expenses incurred in the production of interest or dividend income described in this subsection to the extent that such expenses ... are deductible in determining federal taxable income."

By precluding availability of § 77-2741 to a corporation, § 77-2734(2) excluded federal interest from a corporation's net (taxable) income as a base for the Nebraska franchise tax only so long as interest on U.S. obligations was also excluded from income taxation under federal law.

From September 22, 1959, until September 13, 1982, 31 U.S.C. § 742 provided: "[A]ll stocks, bonds, Treasury notes, and other obligations of the United States, shall be exempt from taxation by or under State or municipal or local authority. This exemption extends to every form of taxation that would require that either the obligations or the interest thereon, or both, be considered, directly or indirectly, in the computation of the tax, except nondiscriminatory franchise or other nonproperty taxes in lieu thereof imposed on corporations and except estate taxes or inheritance taxes." (Emphasis supplied.) (31 U.S.C. § 742 was replaced on September 13, 1982, by 31 U.S.C.A. § 3124(a) without any material effect on the question in this case.)

After enactment of the Nebraska franchise tax in 1967, and until 1976, the Internal Revenue Code excluded from "gross" and "taxable" income any interest on obligations of the United States. See I.R.C. §§ 61(a)(4), 63(a), and 103(a)(2) (1970).

By the Tax Reform Act of 1976 (Pub.L. No. 94-455, § 1901, 90 Stat. 1764), Congress amended I.R.C. § 103(a), namely, interest on obligations of a state or its political subdivisions remained excluded from gross income, but, more importantly, interest on obligations of the United States became includable in gross income and ultimately in taxable income. While Congress changed federal law regarding taxability of interest from federal obligations, Nebraska did not alter its franchise tax, which still retained "federal taxable income" as the base for franchise tax liability. Nebraska's failure to adapt the franchise tax in light of the change in federal income tax law resulted in a franchise tax with a base excluding interest from obligations of a state or its political subdivisions but including interest on federal obligations.

The U.S. Supreme Court, on January 24, 1983, decided Memphis Bank & Trust Co. v. Garner, 459 U.S. 392, 103 S.Ct. 692, 74 L.Ed.2d 562 (1983), wherein the court reviewed a Tennessee 3-percent tax on a bank's net earnings which included interest received on U.S. obligations and obligations of states other than Tennessee. The Supreme Court of Tennessee had held that the questioned bank tax was a nondiscriminatory franchise tax excepted by 31 U.S.C. § 742. See Memphis Bank & Trust Co. v. Garner, 624 S.W.2d 551 (Tenn.1981). However, the U.S. Supreme Court held that the Tennessee bank tax discriminated against U.S. obligations, contrary to 31 U.S.C. § 742, and that the Tennessee tax, therefore, deprived U.S. obligations of the immunity from state taxation afforded by federal law.

During an extensive hearing before the Nebraska Legislature's Committee on Revenue, serious question was raised about Nebraska's franchise tax in view of Memphis. Measures were suggested in committee to cure or eliminate the "discriminatory provision in the current corporate franchise tax." See Introducer's Statement of Intent, Committee on Revenue, L.B. 619, 88th Leg., 1st Sess., and committee hearing (Mar. 16, 1983). Floor debate in the Legislature included reference to Memphis (the "Tennessee case"), the effect of that decision on the Nebraska franchise tax, and the "discriminatory manner" in which the franchise tax was applied regarding federal obligations. See Remarks for Special Permission to Introduce Bill, 88th Leg., 1st Sess., 1075 (Feb. 28, 1983), and Floor Debate, L.B. 619, at 4103 (Apr. 27, 1983). By a vote of 45 to 1, the 1983 Legislature passed L.B. 619 on May 18, 1983, and deleted from § 77-2734(2) the phrase "without regard to the modification referred to in section 77-2741." See § 77-2734(2) (Supp.1983). The Governor signed L.B. 619 on May 23, 1983. As a result of such amendment in 1983 and through the statutory conduit of § 77-2741, the Nebraska franchise tax incorporated the provisions of § 77-2716(1), which in substance authorizes subtraction of federal interest or dividends from federal taxable income, and, before such reduction of federal taxable income, the amount to be subtracted shall itself be reduced "by any interest on indebtedness incurred to carry the obligations or securities ... and [for] any expense incurred in the production of interest or dividend income ... to the extent that such expenses ... are deductible in determining federal taxable income." Id.

Generally, if a tax requires that earning income and exercising the privilege of doing business in a corporate form coincide before imposing tax liability, such tax is properly characterized as a franchise tax. See, Educational Films Corp. v. Ward, 282 U.S. 379, 51 S.Ct. 170, 75 L.Ed. 400 (1931); Flint v. Stone Tracy Co., 220 U.S. 107, 31 S.Ct. 342, 55 L.Ed. 389 (1911); Reuben L. Anderson-Cherne, Inc. v. Commr. of Taxation, 303 Minn. 124, 226 N.W.2d 611 (1975). A franchise tax may be described as a tax imposed for the privilege of doing business as a corporation within a state. There is no doubt, and the parties concede, the tax imposed by § 77-2734(2) is a franchise tax.

The Attorney General, relying on Memphis, requests this court to declare invalid that part of the pre-1983 Nebraska franchise tax which conflicts with federal law [31 U.S.C. § 742; 31 U.S.C.A. § 3124(a) ].

The Commissioner contends that the Nebraska franchise tax does not discriminate against federal obligations, because the franchise tax does not "single out such obligations for special, burdensome treatment." Brief for Defendant at 10.

There are two parts of the U.S. Constitution affecting our decision, namely, article I, § 8, clause 2: "[The Congress shall have Power] To borrow Money on the credit of the United States," and article VI, clause 2, often called the supremacy clause: "This Constitution, and the Laws of the United States which shall be made in Pursuance thereof; and all Treaties made, or which shall be made, under the Authority of the United States, shall be the supreme Law of the Land; and the Judges in every State shall be bound thereby, any Thing in the Constitution or Laws of any State to the Contrary notwithstanding."

Chief Justice John Marshall captured the essence of the supremacy clause by his expressions in two noteworthy cases decided shortly after adoption of the U.S. Constitution. "[T]he States have no power ... to retard, impede, burden, or in any manner control, the operations of the constitutional laws enacted by congress to carry into execution the powers vested in the general government. This is, we think, the unavoidable consequence of that supremacy which the constitution has declared." M'Culloch v. State of Maryland, 17 U.S. 316 (4 Wheat. 316, 436) 4 L.Ed. 579 (1819). "But the framers...