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Commerce Clause

State Taxation Of Nondomiciliary Corporations

In February 2000, the U.S. Supreme Court added another layer to its sometimes complicated Commerce Clause JURISPRUDENCE when it held that the Commerce Clause forbids states from taxing income received by nondomiciliary corporations for unrelated business activities that constitute a discrete business enterprise. Hunt-Wesson, Inc. v. Franchise Tax Bd. of Cal., 528 U.S. 458, 120 S.Ct. 1022, 145 L. Ed. 2d 974 (2000)

Hunt-Wesson Inc., a California-based corporation, was the successor in interest to the Beatrice Companies Inc., the original taxpayer in the case. During the years in question, Beatrice was domiciled in Illinois but was engaged in the food business in California and throughout the world. For the purposes of this lawsuit, Beatrice's unitary operations consisted only of those corporate family business units engaged in its global food business. From 1980 to 1982, Beatrice also owned foreign subsidiaries that were not part of its food operations, but that formed a discrete business enterprise. For the purposes of this lawsuit, the parties stipulated that these foreign subsidiaries were part of the company's non-unitary business operations.

These non-unitary foreign subsidiaries paid dividends to Beatrice of $27 million for 1980, $29 million for 1981, and $19 million for 1982, income that both parties agree was not subject to California tax under the Commerce Clause. In the operation of its unitary business, Beatrice took out loans and incurred interest expenses of $80 million for 1980, $55 million for 1981, and $137 million for 1982. None of those loans was related to borrowings of Beatrice's non-unitary subsidiaries that made the dividend payments to Beatrice.

On its franchise tax returns, Beatrice claimed deductions for its non-unitary interest expenses in calculating its net income apportioned to California. Following an audit, the California Franchise Tax Board applied the "interest offset" provision in California Revenue and Taxation Code Section 24344. Under that section, multistate corporations may take a deduction for interest expenses, but only to the extent that the expenses exceed their out-of-state income arising from the unrelated business activity of a discrete business enterprise; that is, the non-unitary income that the parties agree that California could not otherwise tax. The Section 24344 interest offset resulted in the tax board reducing Beatrice's interest-expenses deduction on a dollar-for-dollar basis by the amount of the constitutionally exempt dividend income that Beatrice received from its non-unitary subsidiaries.

Beatrice responded by filing suit in California state court to challenge the constitutionality of the law. The trial court struck down Section 24344 on the ground that it allowed the state to indirectly tax non-unitary business income that the Commerce Clause prohibits from being taxed directly. The California Court of Appeals reversed, and Hunt-Wesson, having intervened in the lawsuit as Beatrice's successor-in-interest, appealed.

In a unanimous opinion written by Justice STEPHEN BREYER, the U.S. Supreme Court struck down California Revenue and Taxation Code Section 24344. In reducing an out-of-state company's tax deduction for interest expenses by an amount that is equal to the interest and dividends that the company receives from the unrelated business activities of its foreign subsidiaries, Breyer wrote, Section 24344 enables California to circumvent the federal Constitution.

States may tax a proportionate share of the income of a nondomiciliary corporation that carries out a particular business both inside and outside the state, Breyer observed. But states may not, without violating the Commerce Clause, tax nondomiciliary corporations for income earned from unrelated business activities that constitute a discrete business enterprise. Thus, what California called a deduction limitation would amount to an impermissible tax under the Commerce Clause.

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