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.
