HUNT-WESSON, INC. v. FRANCHISE TAX BOARD OF CALIFORNIA
California's "unitary business" income-calculation system for determining the State's taxable share of a multistate corporation's business income authorizes a deduction for interest expense. The system, however, permits 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. Hunt-Wesson, Inc. is a successor in interest to a nondomiciliary corporation that incurred interest expense. California disallowed a deduction for the expense insofar as it had received nonunitary dividend and interest income. Hunt-Wesson challenged the validity of the disallowance. The California Court of Appeal found the disallowance constitutional. The California Supreme Court denied review.
Does California's exception to its interest expense deduction, which it measures by the amount of nonunitary dividend and interest income that a nondomiciliary corporation has received, violate the Due Process and Commerce Clauses?
Legal provision: Due Process
Yes. In a unanimous opinion delivered by Justice Stephen G. Breyer, the Court held that the provision violates the Due Process and Commerce Clauses. "California's statute does not directly impose a tax on nonunitary income. Rather, it simply denies the taxpayer use of a portion of a deduction from unitary income..., income which does bear a 'rational relationship' or 'nexus' to California," wrote Justice Breyer. "Because California's offset provision is not a reasonable allocation of expense deductions to the income that the expense generates, it constitutes impermissible taxation of income outside its jurisdictional reach," concluded Justice Breyer.
Argument of Walter Hellerstein
Chief Justice Rehnquist: We'll hear argument next in Number 98-2043, Hunt-Wesson v. Franchise Tax Board.
Spectators are admonished, do not talk so long as you're in the courtroom.
The Court remains in session.
Mr. Hellerstein: Mr. Chief Justice, and may it please the Court:
This case involves a constitutional challenge to two mechanisms that California employs to deny nondomiciliary corporations, like petitioner here, an otherwise allowable interest expense deduction.
Each of these mechanisms provides an independent basis for invalidating the application of California statute to petitioner.
First, as respondent has stipulated, California denied petitioner an interest expense deduction entirely because it received nontaxable dividends from nonunitary subsidiaries.
Second, California denied petitioner an interest deduction because those dividends were paid by subsidiaries that did no business in California.
It is worth stressing at the outset, Your Honors, that the second mechanism is indistinguishable from the taxing scheme that this Court struck down in Fulton Corporation v. Faulkner.
Justice O'Connor: Well, I suppose we don't have to answer all the questions here if we were to find that the interest offset is unconstitutional because it taxes income over which California lacks jurisdiction to tax.
That's the end of it, presumably.
Mr. Hellerstein: That is correct, Justice O'Connor.
Either basis would be... would invalidate the statute.
During the tax years at issue here, 1980 to '82, petitioner Hunt-Wesson, which is the successor in interest to the original taxpayer in this case, the Beatrice Foods Company, earned lawfully $ 75 million in dividends from nonunitary subsidiaries.
Now, it is undisputed here that California had no power to tax those dividends under this Court's decisions in ASARCO, and Woolworth...
Chief Justice Rehnquist: Beatrice was an Illinois domiciliary the same way Hunt-Wesson is?
Mr. Hellerstein: Yes, Chief Justice Rehnquist, Beatrice was an Illinois domiciliary.
Actually, Hunt-Wesson is a California domiciliary, but they... again, they were the successor in interest.
During the years at issue we are dealing with an Illinois domiciliary.
Now, during those same years, California denied Beatrice an interest deduction...
Chief Justice Rehnquist: Beatrice, I think.
It's named after a little town in Nebraska, and I think it's pronounced Beatrice.
Mr. Hellerstein: Beatrice.
Mr. Chief Justice, I will pronounce it Beatrice.
Justice Stevens: Smart move.
Unidentified Justice: [Laughter]
Mr. Hellerstein: During these years, Beatrice received a... its interest expense deduction was denied on a dollar-for-dollar basis simply because it received these nontaxable dividends.
There is no evidence, no evidence at all in this case that the interest expense bore any relationship to these dividends.
Indeed, even if we had proven... if we had proven that every penny of our interest expense had gone to generate California taxable income, we would have been denied this interest expense deduction simply because we had these nontaxable dividends.
Justice Stevens: Let me ask this question.
What if the interest expense had been incurred to generate different nonunitary income.
Say you borrowed money to buy a lot of securities in Japan, whereas the income here is from income from securities in Germany, would it then be permissible?
Do you understand my question?
Mr. Hellerstein: I'm not sure.
I mean, the way that...
Justice Stevens: I want to give you a hypothetical in which the interest expense is incurred to generate nonunitary income but not the nonunitary... not the same nonunitary income that might be earned elsewhere.
Mr. Hellerstein: Yes, Justice Stevens, I understand your question, and the answer to your question is that this statute works regardless of any proof of any relationship.
Justice Stevens: I understand.
Mr. Hellerstein: There could be a relationship, there couldn't be a relationship.
It's like throwing darts at a dartboard.
Chief Justice Rehnquist: Well...
Mr. Hellerstein: It might work, might not.
Chief Justice Rehnquist: Well, maybe in Justice Stevens' hypothetical it wouldn't be deductible in the first place.
Mr. Hellerstein: Well, in Justice Stevens' hypothetical, if we have interest expense, under the California regime we get the deduction first against any interest, business interest income we have, and then we're denied the deduction if we have the nontaxable dividends.
Chief Justice Rehnquist: But the interest has to be business interest income, does it not, used for a purpose... the money has to be used for a purpose in connection with the business, or does it not?
Mr. Hellerstein: The interest expense that we have, the interest expense is defined at the Federal level.
We use a Federal taxing scheme, so the Federal Government does not distinguish between whether or not the interest expense is business or nonbusiness.
Now, under the California statute and under their own... or their own schedule, the very first thing we do is, we take any interest expense that is, in fact, attributable to the nonbusiness income, and we take that out of the mechanism.
Then the only thing that is left is the interest expense associated with the business.
It is that interest expense that in fact is put into this little mechanism that California has that denies us on a dollar-for-dollar basis the deduction against the nonunitary dividends.
Justice Souter: Is that the subject of that...
Was that the subject of sort of the disagreement as to whether in fact under the California scheme you are supposed to deduct the nonbusiness income from... interest expense from...
Mr. Hellerstein: That is correct, Justice Souter.
Let me explain that, because there has been a dispute, and both sides say the dispute doesn't matter.
Justice Scalia: Could you tell me, for...
Mr. Hellerstein: Yes.
Justice Scalia: I was about to ask what you mean by nonbusiness interest expense.
Is it just interest expense, or nonbusiness income, for that matter?
Does that mean just income that California can't tax, or does it have some other meaning?
Mr. Hellerstein: Yes.
Justice Scalia: Let's get a definition.
Mr. Hellerstein: Okay.
Let's start with nonbusiness income.
Nonbusiness income is income that under this uniform statute that many States have is allocated, that is, is sent to one jurisdiction or another, rather than put into this mix that's mixed up and apportioned.
Justice Scalia: It's really business income that just can't be taxed...
Mr. Hellerstein: Oh...
Justice Scalia: in this case by California.
Mr. Hellerstein: Well, let me... I must be a bit more... I've got to polish it a bit, because in our case that's correct.
In our case the particular nonbusiness income we're talking about are nonunitary dividends, and there's no dispute that California can't tax that.
If, for example, Beatrice had an unrelated beauty parlour in California, California could have taxed that.
That might be nonbusiness income, but if it was in California it could have been taxable.
But in this case, there's no distinction.
There's no dispute that the nonbusiness income is not taxable.
Now, to answer your question about what is nonbusiness interest expense, I think we use that term, and I don't think there'd be any disagreement here, we would use that term to describe any interest expense that could be directly traced to the nonbusiness dividends.
If, for example... and there's no evidence in this case that anything like this happened... if, for example, we had gone out and borrowed money to acquire the nonunitary subsidiaries, and you could trace that borrowing to the nonunitary subsidiaries, then to be sure you would have nonbusiness interest expense, and we would... our position here is that California could probably deny that.
They could probably deny it if they had a tracing mechanism, which they don't, if they said, we've seen that you've gone out and you borrowed money to buy something that's going to generate income that you can't tax, we accept that.
Indeed, we even accept their notion, which is that it's impossible to trace.
All interest is fungible.
All the money is fungible.
Who knows where we use this.
Again, we can... we accept that proposition.
The problem is that California statute doesn't implement that proposition.
When, in fact, you don't know where the interest expense is earned, that is, you can't do the tracing that we're talking about, what do jurisdictions do?
Justice Kennedy: I'm not sure what you accept insofar as the fact that all money's fungible and can't be traced.
You say you accept that proposition.
Mr. Hellerstein: No, what I'm saying is...
Justice Kennedy: And that's... it seems to me that you might accept that proposition in some instances, but not in every instance, or then you'd lose your case.
Or am I wrong?
Mr. Hellerstein: I think, Justice Kennedy, I don't believe you're right that we'd lose our case, because we're willing to... we accept the proposition that a State can reasonably take the position, and California in this case could reasonably have taken the position that all money is fungible, and therefore it is impossible ever to trace on a direct basis a dollar of interest income to a dollar of interest expense.
But even accepting that proposition, one thing is clear from... when you accept that proposition that you are then saying, you don't know where money is coming from or going, but then it cannot be... it cannot be assigned disproportionately to nontaxable income rather than to taxable income, so even accepting the notion that money is fungible, all we're saying... and we're not saying... we're not trying to constitutionalize any particular methodology.
All we're saying is, do what 48 other State, or 45 other States do, do what the Federal Government does.
Spread it around on any of a variety of reasonable bases, including, if you'll read the letter that California's already written to General Electric if they lose this case, spread it around based on where your assets are.
That is, if you don't know where your money's coming from...
Justice Kennedy: Or deny the deduction altogether.
Mr. Hellerstein: Justice Kennedy, if California wanted to deny all interest deduction to all taxpayers, whether they had taxable or nontaxable income, we wouldn't be here.
We think that's quite arbitrary.
It might no longer be a net income tax, but that's not the constitutional issue raised by this case.
The problem here is that what California has done is, under the guise of saying money is fungible, come up with a mechanism that disproportionately assigns income, at least in our case, to the nontaxable income, so based on the undisputed facts of this case, California's taken the position that somehow we never make a dollar, a penny... we never make a penny from interest expense invested in nonbusiness income.
Chief Justice Rehnquist: But if California could deny interest deductions in toto... your claim here is more of an equal protection claim, that you've been treated differently than other California corporations similarly situated, and I'm not sure that's made out.
Mr. Hellerstein: No, Chief Justice Rehnquist, our claim is that while we agree that California could have an across-the-board nondiscriminatory treatment of interest expense, what California is doing, and the court below held... the trial court held they were violating the Equal Protection Clause, but we've not raised that here.
We're saying that what this does, what this statute does is two things.
First, it sweeps nontaxable income into the tax base.
That's a due process violation.
That's an extraterritorial component.
California in fact says that we're going to measure your tax by these dividends out there that we can't get our hands on under ASARCO, under Woolworth, number 1.
Number 2, we're also... in our view this also has a discriminatory component, because when you look at who gets this interest deduction it's only the domiciliary rather than the nondomiciliary.
As arbitrary as the statute is, it helps the domiciliary because these... this interest expense is always attributed to the nonbusiness income, which in this case would be taxable by California, so the nondom... so the domiciliary gets the full tax deduction, whereas the nondomiciliary...
Justice Breyer: Oh, I don't see how that helps you.
I mean, I'm not saying that you don't have a good case in the other part, but I mean, after all, it's an Illinois corporation.
I take it if they allocate all of the interest income to the Illinois Mongolian sheep farm, that Illinois, they'll get the deduction on the Illinois income tax.
Mr. Hellerstein: No, Justice Breyer, because Illinois does not have this arbitrary system like California does.
Illinois would take the position that this... one of two positions.
I'm assuming it could either trace... it could say, we're going to directly trace...
Justice Breyer: Do you know, does that really happen?
So in other words when California insists that the tin can business allocates its interest income to its Mongolian sheep farm, the... Illinois will not allow them to deduct that interest expense that California shifted over there.
Mr. Hellerstein: That is correct.
In other words... let me just make sure that I... I mean...
Justice Breyer: I'm making up... what I keep...
Mr. Hellerstein: Yes.
No, but... no...
Justice Breyer: is, in my mind I imagine a tin can company selling all over the United States.
It owns a Mongolian sheep farm.
Mr. Hellerstein: Exactly, and...
Justice Breyer: Okay.
Now... go ahead.
Mr. Hellerstein: And therefore the... this would... it would generate nonbusiness dividends.
California would say, gee, you have interest equal to those nonbusiness dividends, no deduction, and then in Illinois... then the question would be whether Illinois would take the same position, and the answer is no, because Illinois, being a State that is not off the radar screen like California, but does what other States do, they'd look at their interest expense, see whether or not this interest was associated first with the Outer Mongolian sheep farm.
If it wasn't... if it was, they get the deduction, because this is a domiciliary State.
If it wasn't, it would go into the pool and they might spread it around, so that's how it would work.
Justice Ginsburg: Mr. Hellerstein, your position is not that California couldn't reject any part of this.
It could have an offset, but it as to be according to some apportionment, some reasonable apportionment.
Mr. Hellerstein: That is precisely right, Justice Ginsburg.
Our position is that there are a wide variety of acceptable methodologies for assigning or allocating income to various jurisdictions.
They're in place in all of the States, they're in place at the Federal level, and what we're simply saying is that you cannot have allocation by wishful thinking, which is essentially what California has here.
It's a simply...
Justice Scalia: What is... assuming we agree, but what does California do with respect to these back years that have already been treated this way?
Mr. Hellerstein: Well, I can tell you that our...
Justice Scalia: Can it adopt a, what you would consider a constitutional rule, and apply them to those past years?
Mr. Hellerstein: Justice Scalia, I can only speak to two specific situations that... one that I'm aware of because it's our case, another because it's in the amicus brief.
Certainly with regard to our case there has been... we have stipulated to the refund to which we're entitled should we prevail in this case.
It was my understanding from... certainly from the letter that California has written to General...
Justice Scalia: On the basis of what, some kind of apportionment scheme that you're willing to accept?
Mr. Hellerstein: No.
The stipulation... the stipulation was based on a... it was an all-or-nothing proposition.
We were going... there might have been settlement negotiations earlier, but at this point we agreed here...
Justice Scalia: You'll get it all back.
Mr. Hellerstein: If we win.
Justice Scalia: And it's too late for them to say, okay, we'll apportion some of it.
They... none of it would be...
Mr. Hellerstein: For these particular years, that is correct, Justice Scalia.
However, I think it's quite clear, from the letter appended to the General Electric's brief, that California is aware of this litigation, they have written letters to General Electric and presumably to other taxpayers saying, and by the way, if we lose this case, you'd better apportion your interest expense by a reasonable amount, namely an asset allocation method, so I...
Justice Kennedy: Well, on that basis maybe you could help me understand what the State says in its red brief at page 21.
It says, if a deduction of the entire amount of interest expense is allowed, the corporation stands to gain a tax windfall, and then it goes on.
I take it that's only because California does not have an apportionment system in place, is that correct?
Mr. Hellerstein: I think frankly...
Justice Kennedy: I mean, is that the way you would answer that?
You'll say, well, sure, but if you have an apportionment scheme in place like other States do, there won't be a windfall.
Is that how you answer that?
Mr. Hellerstein: Actually, Justice Kennedy, the way I would answer that, I think that's because of California's Californiacentric view of the universe.
In fact, there is no windfall, because Beatrice pays taxes in 45 other States, so that the... any income... we're not talking about tax exempt municipal bonds here.
I mean, income that California says is not taxable in California because it's not a unitary... part of the unitary business is presumably taxable somewhere else.
The only time there would be a windfall would be if the income that California is not taxing under a proper scheme is somehow not taxed by the other jurisdiction.
Justice Kennedy: Well, is the answer there wouldn't be a windfall if there were an apportionment scheme?
Would you accept that answer?
Mr. Hellerstein: I would certainly accept that if California apportioned in the way that other States apportioned, there would be no windfall, that is correct.
Chief Justice Rehnquist: But you don't contend, do you, Mr. Hellerstein, that California has to have the same method of taxing that... even if 48 other States have it, the Constitution doesn't require them to have...
Mr. Hellerstein: Absolutely not, Mr. Chief Justice.
We are saying that there are... we are saying that their method is so far off the radar screen, is so different from any method that even approximates a reasonable method, and there are a large variety of them, whether it's assets or gross receipts or net income, any of those would be appropriate.
Indeed, to look at this Court's own opinions, this Court has looked at this problem in a number of instances, generally when the question was whether or not a taxpayer, or how a taxpayer should attribute expense between taxable income and tax exempt income, generally either municipal bond income that wasn't taxable at the Federal level, or alternatively, Federal taxable income that wasn't taxable by the States, and what the Court has said... when the Court has looked at this, the Court has really rejected both extremes.
The Court has rejected the extreme view of the States, which has been to say... or the taxing authority, when the taxing authority has said, you may not deduct 1 penny of this expense... that is, the expense must be matched dollar-for-dollar against the tax-exempt income, which is what the... the kind of situation that arises in National LIfe, the Court said, you can't do that, because that really undermines the exemption.
On the other hand, when taxpayers have been greedy, when taxpayers have said, we don't want $ 1 of our expense assigned to our nontaxable income, because that undermines the exemption, the Court has said no, that's not right, either.
What the Court has said is really precisely what most States and thel Federal Government have said in this kind of situation, is when you don't know, when you can't trace the amounts, what you do is, you spread it evenly.
This Court has said, there's no reason in law, or no sound legal or economic reason for distinguishing between the taxable and the nontaxable dollar.
That's the theme.
So long as there is some reasonable apportionment between taxable and nontaxable, that, I think, is all the Constitution requires.
What the Constitution forbids is a disproportionate assignment of income to values that cannot be taxed.
Justice Breyer: Can you... because I'm not totally familiar.
Which part of the Constitution forbids that?
Mr. Hellerstein: Forbids...
Justice Breyer: I mean, let's assume you're completely right.
Mr. Hellerstein: Right.
Justice Breyer: This is totally irrational.
I mean, it's completely unfair.
They're taxing income that arises in other places.
What is... what... can you just trace through for 1 second what the argument is that that violates the Constitution?
Mr. Hellerstein: Yes, Justice Breyer.
It will depend on...
Justice Breyer: I know there will be cases that support you, but I mean, what's the reasoning?
Mr. Hellerstein: Well, I guess, you know, it would depend on the provision.
Well, the basic thought is that by arbitrarily denying the deduction you are taxing the income, so...
Justice Breyer: And what prevents California from taxing income from Mongolia, or Illinois or something?
Mr. Hellerstein: The Due Process and the Commerce Clause, as this Court has held in Allied-Signal and ASARCO and Woolworth.
In the intergovernmental immunities cases, that is, when we're dealing with... let's deal with the modern cases.
We're dealing with State taxation of Federal obligations such as in the Barker Bank case.
There, Georgia would have been forbidden under the... under McCullough v. Maryland, but as embodied in, know in Federal statutes from taxing the Federal income.
Some of the earlier cases are based on the...
Chief Justice Rehnquist: But the Federal principle that a State can't tax a Federal entity wouldn't necessarily carry over if you weren't dealing with a Federal entity.
Mr. Hellerstein: Well, Chief Justice Rehnquist, the way the cases have arisen with regard to that issue, that is, it is a given proposition of... I think of Federal constitutional law and also valid Federal statutory law that States may not tax income from Federal obligations, so a State, for example, could not come along and deny, as California has denied, an interest expense deduction arbitrarily assigned to every dollar of Federal income that it can't tax.
Chief Justice Rehnquist: Yes, but income from a Federal obligation may be different for constitutional purposes than income from some other kind of obligation.
Mr. Hellerstein: That is correct.
That is correct.
Justice Breyer: And so what is it that... one day California says, you know, we're taxing people.
We don't want to be fair, and what we're going to do is, we are going to tax income that arises in Illinois, and moreover, it's going to be terrible, because companies are going to have to pay more tax than they have income.
Justice O'Connor: Well, I thought we'd held in Allied-Signal that it violates the Due Process Clause...
Justice Breyer: That's what I wondered.
Justice O'Connor: for a State to tax...
Justice Breyer: It's the Due Process Clause that it does that...
because it takes their property without due process.
Mr. Hellerstein: It is both, indeed, as Justice O'Connor was pointing out, and in Allied-Signal the Court said that the extraterritorial analysis, or the bar on State taxation of extraterritorial values is rooted both in the Due Process and the Commerce Clauses, so you'd have two constitutional bases for that.
Justice Ginsburg: Well, what about the argument that, indeed, your client is getting a windfall because home States like Illinois give a tax break for this category of investment income?
Mr. Hellerstein: Well, in fact, Justice Ginsburg, Illinois is not a tax haven, and during the years at issue here, the... and this... by the way, these were years during which there was considerable uncertainty as to whether or not income was apportionable.
There were the... this Court... some members of this Court will recall the ASARCO and Woolworth and container cases in the eighties, where there was uncertainty.
Illinois had a regulation at that... during those years that actually allowed a domiciliary corporation like Beatrice, and the regulation is 300-2(c)(2)(A), that during those years allowed a domiciliary corporation to apportion its income.
Now, that was a decision made by Illinois.
Illinois had the constitutional power, and indeed our... it is stipulated in the... it's... I believe it's stipulation, paragraph 8.
It's stipulated that nonunitary dividends were taxable by the State of Illinois, so there's no windfall tax haven issue here.
Justice Scalia: You don't think that matters, though, do you, anyway?
Mr. Hellerstein: No.
Justice Scalia: If Illinois decides to be generous and not tax something, California, if it has no jurisdiction to tax, can say, hey, you know, somebody's getting a break.
We ought to be able to reap that tax.
Mr. Hellerstein: That...
Justice Scalia: It would still not be... not be justified.
Mr. Hellerstein: That is precisely right, Justice Scalia.
California's power to tax does not expand based on Illinois' decision whether or not to tax.
We'd have... I'd like to reserve the next 5 minutes for rebuttal.
Argument of David Lew
Chief Justice Rehnquist: Very well, Mr. Hellerstein.
Mr. Lew, we'll hear from you.
Mr. Lew: Mr. Chief Justice, and may it please the Court:
I think the issue before this Court can be simply stated, and that is, what interest expense is California constitutionally required to treat as a tax deduction?
As this Court has held, a State bears no constitutional obligation to permit a taxpayer to take a deduction for an expense which relates to income which that State is barred from taxing.
The petitioner in this case has conceded that States such as California have the constitutional authority to allocate expenses to different streams of income and, more importantly, concedes that States have the authority to do so by applying formulas that assign interest expense to income that is not taxable by the State of California.
The petitioner's narrow...
Justice O'Connor: Yes, but the problem here is, California has chosen to allocate 100 percent of the taxpayer's interest expense in excess of its business interest income to its generation of nonbusiness income that's not taxable by California.
Mr. Lew: Well, the...
Justice O'Connor: I mean, it's California's choice to have this scheme, and it's enacted one that does raise concerns of trying to tax extraterritorial income, in effect.
I mean, California wouldn't have to do it this way.
California could have a reasonable allocation method.
But what's the rationale for this scheme it does have, which just seems to go beyond what California is authorized to do?
Mr. Lew: Well, the answer to your question, Justice O'Connor, is that what California is trying to do with this statute is basically eliminate a double tax benefit that arises whenever a corporation, number 1, incurs debt, and there is therefore interest expense generated by that debt, and at the same time has funds invested in nontaxable activities which produce nontaxable income.
The problem is that part of the debt either directly or indirectly is used to support the nontaxable activities.
Justice Kennedy: But you solved that problem by denying it against all nonunitary income whether or not the interest expense was related to it.
Mr. Lew: Well, what the statute is attempting to do, Justice Kennedy, is to essentially close that loophole in the most effective way possible.
Justice Kennedy: Well, of course, it's always effective if you deny apportionment.
Mr. Lew: Well, the theory behind doing it on a dollar basis... and if I may just take one step back.
The formula first allocates interest expense to... against the corporation's business interest income on a dollar-for-dollar basis.
Justice Kennedy: And if the business interest is big enough, then there's going to be no problem.
Mr. Lew: That's correct.
All of it is... all of it is deductible.
Justice Kennedy: Of course.
Mr. Lew: To the extent that any remains, that is allocated also on a dollar-for-dollar basis against the corporation's nonbusiness income, and again it's intended basically to eliminate the possibility that any amount of that interest expense which is related to the generation of income that's not taxable by the State of California is used by the corporation to reduce its California tax base.
Justice Kennedy: Yes, but it's not allocable against all its nonbusiness income.
Mr. Lew: It's... well, the answer to your question is, it's allocable against its nonbusiness interest and dividend income.
That's what the statute calls for.
Justice Breyer: My can company has no business interest income.
It's not in the lending business.
It sells $ 1 million worth of cans in California.
It happens to borrow about $ 900,000 to get the tin.
Now, what conceivable reason does California have to allocate that $ 900,000 that they used to buy the tin for the cans to some kind of income it has from the sheep farm in Florida?
Mr. Lew: Because the money that is borrowed basically is... can't... is used to free...
Justice Breyer: Say you don't know.
Maybe they're lying.
They said they used it for tin, but maybe they're not telling the truth.
Okay, other States have dealt with that problem by saying, since we can't trust anybody here, and it's hard to trace, what we'll do is, we will proportionately allocate.
If you have a million coming in from the tin business, and you have 100,000 from the sheep farm, do it 10 percent to the sheep farm, 90 percent to the tin.
Now, why... what possible reason is it for not taking some variation on that theme?
Of course, if you can show it went to the sheep farm, that's the end of it.
But where you just don't know...
Mr. Lew: There's nothing wrong with a proportional approach, Your Honor, except that it doesn't really close the loophole.
Justice Breyer: How does it not close the loophole?
Mr. Lew: Because to the extent that less than $1 of interest expense is used to offset a dollar of nonbusiness income, there's still that differential that exists.
Justice Breyer: Sure there's a differential, but the sheep farm had nothing whatsoever to do with the lending.
Mr. Lew: Well...
Justice Breyer: I mean, I don't see why you call that a loophole.
Mr. Lew: The assumption is that it's not related, and...
Justice Breyer: Yes, right.
Oh, you mean maybe it is related?
Mr. Lew: Indirectly, yes.
Justice Breyer: Well, maybe the tin is really related, so why don't you allocate all the deduction for the tin to the sheep, too?
Mr. Lew: Well, the answer is that you just don't know that, and what... and what California is trying to do is to prevent any of that interest that might be related to the generation of income that it cannot tax to be used to reduce its California tax base.
Justice Souter: Well, when you say they just don't know, what you're referring to is the... a process in which most States know by virtue of a reasonable apportionment formula, and so when you say, well, we just don't know, that seems to be the equivalent of saying, well, we can't apportion, but you clearly can.
Mr. Lew: Well, there's no problem, constitutional problem with apportionment.
I mean, that is one way to deal with the problem for sure, but to the extent that interest in fact does relate to nonbusiness, or nontaxable income, there's still that... there's still that possibility that a portion of the interest expense that in fact relates to generation of nontaxable income is going to be applied to reduce the corporation's California taxes.
Justice Souter: Yes, but you don't know either, and instead of adopting an apportionment formula, what you in effect do is adopt an irrebuttable presumption, and as against an apportionment formula, which provides a rational basis, and an irrebuttable presumption which ignores the facts, due process normally requires the rational process.
Mr. Lew: Well, I can only say that the objective of the State is to attempt to eliminate that possibility of the taxpayer receiving a double tax benefit.
Justice Souter: Oh, you certainly do that.
Unidentified Justice: [Laughter]
Justice Souter: No question.
Justice Scalia: You achieve that objective.
Unidentified Justice: [Laughter]
Mr. Lew: And toward that objective it seems that the way that California does it is reasonable, because a dollar-for-dollar offset of interest expense and interest or dividend income basically returns the corporation to the same economic position...
Justice Souter: Well, it does if there's a dollar-dollar relationship between the expense and the income, and you're in effect saying, we don't care.
We will simply assume that, and we will assume that by means of this presumption, and due process requires rationality, not irrebuttable presumptions.
Mr. Lew: Well, you know, we can't say that it does or it doesn't.
Justice Scalia: But you have to say that it does.
You don't have a right to send a tax bill to every nondomiciliary of California for all of their income, and you say, well, you know, we can't be sure that we can't tax it.
Unidentified Justice: [Laughter]
Justice Scalia: It's just irrational.
You either demonstrate that it comes from this other nontaxable income, or... or, if you can't demonstrate it, then, you know, do a reasonable apportioning, but you do neither one.
You're just saying, here, here's a tax bill, pay it, or we're not sure where this income comes from, but we don't want you to get away with something.
Mr. Lew: Well, it seems to me that the economic reality... the dollar-for-dollar allocation is really an attempt to reflect the economic reality that interest income is the economic counterpart to interest expense.
If a corporation borrows money...
Justice Stevens: If you treat the interest as paid... say you have a mortgage on a new plant that you're using in California.
You treat it as the functional equivalent of interest to buy securities in Mongolia that are going to have nothing to do with the unitary business.
You just merge all of your interest income and treat it as fungible.
Mr. Lew: That's...
Justice Stevens: Your interest expense, I mean,...
Mr. Lew: That's correct.
Justice Stevens: Yes, and notwithstanding the fact that it's very easy to identify that in fact some of the income produced by those borrowings is not part of the unitary business.
Mr. Lew: Well, I think that if the Court accepts the notion of fungibility, then the problem is being...
Justice Scalia: If it wasn't spent there, it could have been spent elsewhere, so it's hard to say that it necessarily went to this.
It's saving you spending other money elsewhere.
Of course, that's true.
Mr. Lew: That's correct.
Justice Scalia: But if you adopt that fungibility principle, which your opponent is quite willing to accept, what it leads to is not the conclusion that you can tax all of it, but the conclusion that you should apportion it.
Mr. Lew: Well... well, I disagree with the idea that it is being taxed.
After all, the formula itself allows as a first step an allocation of interest expense against a corporation's business interest income, so to the extent that the amount of business interest income is... swallows up the entire amount of the expense, then all of it is allocated to reduce the corporation's California taxes.
Justice Breyer: I don't see what that... I mean, most businesses, except if they're in the financial business, don't have a lot of business interest income compared to their other business, so I don't think that helps too much, does it?
Mr. Lew: Well, I think it... I think it demonstrates that the statute applies its rules in a fair and even-handed way.
I mean, certainly it is possible under California's statute for a corporation to come out better than it would under a proportional approach, and I think that that is one of the things that has to be understood, that the statute does allocate interest expense to interest income and dividend income in a fair and in an even-handed basis.
In fact, the first step of the statute allocates it to business interest income.
And with regard to the... what the statute does, it basically shifts those deductions which it considers to be attributable to nontaxable income to the... it attributes it to the income which is then taxed... which is then allowed as the deduction by the State of domicile if, in fact, that State utilizes a statutory scheme which is similar to California's.
Now, it is true that none of the other States currently adopt such a provision, but under this Court's internal consistency analysis I'm not sure whether or not that's a constitutionally significant point.
If in fact it were the case that all of... that all States utilized this formula, then the taxpayer would be able to have the benefit of all of the deductions which California has essentially shifted over to the State of domicile and enjoy a reduction in its nonbusiness income in that State.
It... the statute simply attempts to assign interest expense to its proper use or application, and it does so on a dollar-for-dollar basis against its business income and against the corporation's nonbusiness income.
In that sense, it is applied even-handedly, and again, those deductions would be available to the corporation in the State of domicile under a consistent... internal consistency analysis.
Now, as I said, the proportionality approach is one way of dealing with the problem, but again it doesn't solve the problem of a corporation obtaining a tax benefit completely, because to the extent that less than...
Justice Scalia: Wait, only if Illinois or, you know, some other State decides to give it the tax benefit, and that's none of your business.
If some other State wants to give them a tax double benefit, that's none of California's business.
Mr. Lew: Sure.
Justice Scalia: So... but that's the tax benefits you're talking about.
Mr. Lew: No.
I'm talking about the tax benefit that arises when a corporation incurs debt, is able to write off the interest expense from that debt, and at the same time use that debt, either directly or indirectly, to generate income which California is not permitted to tax.
That is the double tax benefit that I'm talking about.
Justice O'Connor: Yes, but California asserts here the right to treat it as though it was all used, the money, to generate nonbusiness income.
Mr. Lew: That's right.
That is correct.
Justice O'Connor: Even though we know on the facts of this case, don't we, that that isn't true, and there's no move made by California to do any allocation.
Mr. Lew: Well, I don't agree that under the facts of this case that was... that is, in fact, the case.
If the Court is... if Your Honor is referring to the stipulation, then I don't believe that that is what the parties stipulated.
If the parties stipulated...
Chief Justice Rehnquist: Where are you reading from, Mr. Lew?
Mr. Lew: I'm reading from joint appendix page 21, stipulation number 14.
I believe that is what Justice O'Connor was...
Justice O'Connor: Well, that doesn't cover that point, but... and I can find it elsewhere, I assume, but let me ask you this.
Let's assume what I said is true.
The effect of the California provision would be to not allocate it at all.
Mr. Lew: It... well...
Justice O'Connor: You treat it as though all of the expense incurred in borrowing money went to the outside nonunitary business.
Mr. Lew: Well, what... again, and I know that I've said this before, what California is attempting to do is basically ensure that none of the interest expense was used, in fact, to generate income which California's not permitted to tax.
Chief Justice Rehnquist: Is it your position, Mr. Lew, that California in the long run, by its system, doesn't... is not able to tax any more income than it would be by the proportionality just because some people get a break and others don't under it?
Mr. Lew: I'm not sure if I understand your question completely, Your Honor, but let me try to answer it this way.
I think that the argument... the criticisms that can be leveled against California's statute can also be leveled against a proportionality approach in the sense that a certain portion of interest expense is being allocated to nonbusiness, nontaxable income.
Now, we don't know whether or not the amount that was allocated is the correct amount, but it does have the effect of increasing the corporation's tax in the State of California, so to the extent that that can be viewed as an indirect taxation of nontaxable income, that is what is being done there, and that's the same criticism that's being made in our case as well.
Justice Breyer: You can't ask the State to do more than it can do.
I mean, if it's hard to do it, hard to allocate it, that's an effort, that's a reasonable effort, so they're not unreasonable when they make a reasonable effort, even if it doesn't all work out perfectly.
But given the possibility of that reasonable effort, what justification is there for taking the money that's not apportionable?
Mr. Lew: Well, again... same argument, Your Honor, and that I think is... it's a reasonable objective, and the approach that it takes is the surest way of closing that loophole.
Justice O'Connor: Well, it's sure all right.
It's 100 percent dollar-for-dollar.
I mean, it makes no effort to apportion, and you're going to have to persuade me that that's reasonable, because I don't find anything in what you've said that makes me think that's reasonable.
No other State does that.
There's no effort made to allocate it.
I just... I have yet to hear a reason.
Except I want to be sure, 100 percent sure.
I guess the California supreme court case on which the California court of appeal decision here was based was decided a long time ago.
Mr. Lew: That's correct.
Justice Scalia: Before our decisions in Allied-Signal and ASARCO.
Mr. Lew: That's correct.
Justice Scalia: Right.
And it's sort of hard for you to give up that old 1972 California supreme court opinion.
Unidentified Justice: [Laughter]
Mr. Lew: Well, I think that... I think that in that the court, the California supreme court has held that it does not result... that the allocation of interest expense to nontaxable income on a dollar-for-dollar basis does not constitute a tax, I think it's still applicable here, even in light of Allied-Signal and other cases.
Justice Ginsburg: The argument has been made that if you look at how the Federal taxation works, income taxation, in the main there is an allocation, but there's also an argument that at least in one respect the Federal income tax... I forgot whether it's... it has something to do with foreign investment, or foreign corporations, that the Internal Revenue Code does what California does in that one discrete area.
Mr. Lew: That is my understanding, yes, Your Honor, that there is a dollar-for-dollar allocation allowed under certain circumstances in the Federal scheme.
Justice Ginsburg: So you could make the argument that if it's rational for the Internal Revenue Code to do that, so it's rational for California to...
Mr. Lew: I think there's a basis for doing that, Your Honor.
I also believe that in... that section 265 of the Internal Revenue Code as well provides for a dollar-for-dollar offset in certain situations.
Justice Breyer: If I'm right... I don't know if this is the only place that does that in the code.
There's a rule which my law clerk found which is a controlled foreign corporation netting rule, and that has to do with a circumstance where you have to allocate income expense to certain foreign source income earned when you lend the money to a controlled foreign corporation and there's both been an increase in lending and an increase in borrowing.
And under those circumstances there is some rationality, where you've loaned more money to your off-shore corporation, and at the same time you've increased the borrowing, so I could at least see a rational there for saying we're going to assume this extra lending is allocated to the extra borrowing, but I don't think you even have anything like that here.
Mr. Lew: Well, I...
Justice Scalia: In other words, it's a tracing rule, rather than an allocation rule.
All that your opponent is asking is that you either allocate or trace, but you've done neither.
Mr. Lew: Well...
Justice Scalia: The Federal provision seems to try to trace.
Mr. Lew: Right.
The California statute is definitely not a tracing rule.
It's actually just an assignment rule, and it's basically based on the idea that it's extremely difficult, if not impossible, to trace interest expense to its ultimate use or application, and again it's just based on the idea that this is what... California's interest in trying to close this loophole.
That's what the statute is trying to do, and I think that to the extent that that constitutes a legitimate State objective, I think it certainly accomplishes that goal, and it does so, I think, in a fair way in the sense that it does allow that first step to allocate interest expense to... on the basis of business interest income, and to the extent that there is any remaining, it does allocate it against its nonbusiness income.
Justice Stevens: Why can't you just ask the taxpayer to assume the burden of persuading you that any interest... any income, or interest deduction that it seeks to obtain is attributable to the unitary business?
Mr. Lew: Well, I think that that is... that is one way to go, but I think that's also subject to manipulation as well, Your Honor.
Justice Stevens: The same is true of payroll and other expenses in this gigantic balance sheet and income statement they have to prepare in these things.
There's always room for...
Mr. Lew: And that's... I think the problem, if you're trying to determine, you know, a corporation's motive, I think that's just, as a matter of tax administration, extremely difficult to do, and it's essentially a facts and circumstances kind of test, and I just think that it's extremely difficult to administer that kind of test, you know, especially for a State like California.
That, I think, is what the problem is, and that is why there is this statute, which essentially eliminates any type of concept of motive or, you know, purpose, and just says, look, if you have interest expense, and you are using some of your capital to generate income that is not taxable in the State of California, that there is the...
Justice Stevens: It does seem to me it's not entirely unlike taking the president of the corporation's salary.
You do some allocating there.
You've got to... you know, there's room for... I don't know why interest is any harder to allocate than something like that.
Mr. Lew: Oh, it's... well, interest is harder to allocate than other... the thing about interest is that it is extremely fungible, I guess is the best way to put it, and you can't...
Justice Stevens: The dollars paid to the president of the corporation are pretty fungible, too.
Chief Justice Rehnquist: Is there any...
Justice Stevens: For salary, I mean.
Chief Justice Rehnquist: Is there any requirement that the interest deduction be based on loans that were made in California, or can they be made anywhere?
Mr. Lew: I believe they can be made anywhere, Your Honor.
Justice Ginsburg: Do you think that California, if we were not to accept your position, and were to say that you have to make some effort to allocate, California could do that...
Mr. Lew: Yes.
I think it...
Justice Ginsburg: without having a new statute that does it?
That is, the example... which company was it that we have in these cases?
Is it General Motors, or General Electric?
I don't remember.
Could the tax commissioner say, well, what we did is no good, here's something else that is good, so we're going to do that even though we don't have a statute that so provides?
Mr. Lew: Yes.
It is my belief that that could probably be done pursuant to other California regulatory authority which allows for a spreading of interest expense similar to the method that has been endorsed by the petitioner.
I don't think that it would necessarily require a... the enactment of a new statute.
I don't really have anything else.
If the Court has any further questions I'll be happy to answer them.
Other than that, I'm done.
Rebuttal of Walter Hellerstein
Chief Justice Rehnquist: Thank you, Mr. Lew.
Mr. Hellerstein, you have 5 minutes remaining.
Mr. Hellerstein: I have three very brief points.
First, with regard to the CFC netting rule that both Justice Breyer and Justice Ginsburg referred to, you're quite right, Justice Breyer, the CFC netting rule is, in fact, a very finely tuned tracing rule, as Justice Scalia said.
It only arises in a situation when there's... you go to some unrelated lender, you borrow money, you then relend that money to your controlled foreign corporation, the controlled foreign corporation then pays you interest.
That's the situation we're talking about.
If California had anything like that, we certainly wouldn't be here.
Again, a finely tuned mechanism addressed to a specific tax evasion problem which actually doesn't even... it just reduces the foreign tax credit, is what we're talking about.
It's not even a... it's not a jurisdictional problem.
Point two, Mr. Lew suggested, gee, these... all these other formulas that we're suggesting are reasonable are vulnerable to the same sort of criticism that we're making, and that's not true.
The criticism that we're making is that the California formula disproportionately assigns interest expense to nontaxable income.
All of those other formulas do it on an even-handed, nondiscriminatory basis.
And finally, his suggestion that, because the statute is internally consistent it is therefore constitutional, is a non sequitur.
It would be... if California had a statute that assigned income based on the number of square miles in a State, that would be internally consistent, but I think would plainly be unconstitutional and, indeed, in cases involving retaliatory taxes, which are entirely consistent, this Court has also held they are unconstitutional.
If the Court has no further questions...
Chief Justice Rehnquist: Thank you, Mr. Hellerstein.
The case is submitted.
Argument of Speaker
Mr. Speaker: The opinion of the Court in No. 98-2043, Hunt-Wesson, Inc. versus Franchise Tax Board of California will be announced by Justice Breyer.
Argument of Justice Breyer
Mr. Breyer: The Federal Constitution permits a state to tax a propionate share of the income of an out of state company that does a particular business both inside and outside the State, but the state cannot tax income that that kind of company receives from an out-of-state unrelated business activity that constitutes a discrete business entity.
So, imagine an Illinois tin can maker that does a $10 million tin can business in every state and suppose that company also has $200,000 dividend income from a completely unrelated New Zealand sheep farm; that means California could tax its share of the tin can income but it could not touch that $200,000 dividend.
Now what has California done?
Well, their system permits the manufacturer to deduct certain cost from income including interest cost; say they produce those tin cans with borrowed money in part.
Well, California says that you can deduct that interest only to the extent that it exceeds the dividend from the sheep farm, so if the company let us say has $300,000 in tin can interest cost, it could not deduct the $300,000, they could only deduct $100,000 because it exceeds the $200,000 dividend by $100,000.
Now, does the Constitution permit the type of deduction system that I just illustrated with this example which is a made up example?
We decide that it does not, we think that California’s deduction rule simply taxes in out of state companies non-unitary income, the vary income that the Constitution places outside the state's taxing power.
Some years ago this Court wrote effectively that a tax on sleeping that is measured by the number of shoes in your closet is not a tax on sleeping, it is a tax on shoes and that basically underlies our reasoning in this case.
Now, California points out that it is difficult to know if the borrowed money is really for the sheep business or for the tin can business and that is a good point, but it does not justify a rule that assumes that all borrowings are really for sheep.
Neither the Federal Government nor any state makes any assumption that is that reckoning, rather every other jurisdiction uses a tracing rule, assumptions or allocates borrowings between taxable and non-taxable sources in some proportionate way.
California has not explained why it could not do the same.
For that reason California’s system in our view does not reflect the reasonable sense of how income is generated.
It is therefore not justified and because it taxes untaxable income the Due Process and Commerce Clauses of the Federal Constitution forbid it.
The lower court decision upholding California’s deduction rule is reversed.
Our decision is unanimous.