Court Rejects State Tax on Multinationals

An appellate court has dealt California another setback in the high-stakes battle to save its so-called “unitary tax” on foreign-based multinational corporations--a ruling that could cost the state hundreds of millions of dollars.

The 3rd District Court of Appeal in Sacramento, deciding in favor of London-based Barclays Bank and its California subsidiary, found that California’s unitary system is unconstitutional because it violates the foreign commerce clause of the U.S. Constitution.

Although the ruling is not expected to have an immediate impact on the state budget problem because of likely appeals that could drag on for months or years, state Controller Gray Davis called it “another dark cloud on the state’s already gloomy finances.”

Davis said the loss to the state, once appeals are exhausted, would be $526 million in back taxes, interest and administrative costs. There also would be ongoing, still unknown losses because of California’s inability to continue levying the tax.

Davis, chairman of the Franchise Tax Board, which administers the tax, said an appeal was all but certain. “As a practical matter, the decision would preclude our auditors from examining the books of foreign-based multinationals,” Davis said.

The ruling, handed down last Friday, marked the latest chapter in a bitter controversy between state tax officials and foreign business interests that has been raging since the early 1970s. Under the unitary system, the state taxes multinational corporations on the basis of each firm’s worldwide earnings, payroll and property holdings. The state figures that if 2% of a corporation’s business operations are in California, then the state should have the right to apply its bank and corporation tax to 2% of a company’s worldwide taxable income.

California established the tax in the belief that unless taxable income is based on a corporation’s worldwide operations, the firm will be able to shift profits from one subsidiary to another, report losses locally, and escape an income tax here altogether.

Foreign business interests contend that California’s unitary method is used nowhere else in the world, requires them to keep separate sets of books, unfairly taxes profit centers outside of California, and requires them to turn over confidential corporate records to state auditors.

In 1983, the U.S. Supreme Court ruled in favor of the state, holding that the unitary system was a legally sound way of taxing corporations. That ruling failed to definitively address the foreign policy questions and whether the state was usurping the federal government’s role in setting tax policy. In the latest decision, the appellate court ruled that the tax usurped federal authority.

In 1986, the Legislature, hoping to defuse the political and legal powder keg, revised the state’s taxing system to give multinational corporations a tax break that now amounts to about $300 million a year. Controversy continued over the unitary tax.

Joanne M. Garvey, a San Francisco attorney who represents Barclays, said the unitary system “has been an international cause celebre from the moment the state tried to apply it.”

Garvey said the unitary method “is contrary to all international tax systems,” contending that “even the federal government has had nothing but problems with it.”

In a unanimous opinion, the Court of Appeal seemed to agree, ruling that the unitary system is unconstitutional because it poses a threat to international commerce and runs contrary to federal policy on taxing of foreign corporations as voiced by the administrations of four Presidents.

The case was filed by Barclays Bank after a state Franchise Tax Board demand that the British firm pay an additional $154,098 in 1977 state taxes.

The governments of the United Kingdom and Canada joined Barclays in the protest, arguing that the tax violates widely accepted international standards and could lead to retaliation against U.S. firms operating in their countries. The U.S. Justice Department joined the two foreign governments in the appeal, arguing against the California tax.

The three-member state appellate panel, in a decision written by Associate Justice Hugh A. Evans, described the tax as “an irritant in our foreign commerce relations” with “adverse implications for American foreign policy.”

The Barclays ruling does not affect a second major unitary tax suit on its way to a decision--filed by Colgate-Palmolive Corp. and representing the legal interests of U.S.-based corporations.

Should the state also lose that suit, Controller Davis said the state could lose an estimated $3.3 billion in tax refunds, penalties, interest payments, fees and lost tax payments.

“It’s scary. It’s one more hole in the dike whose leak is all but fatal now,” said Assemblyman John Vasconcellos (D-Santa Clara), chairman of the Assembly Ways and Means Committee, which is grappling with a budget shortfall that could reach $6 billion over this year and next, even without the adverse court ruling.

On the broader budget front, lawmakers--after a little more than 24 hours in session--returned to their districts Tuesday without acting on Gov. George Deukmejian’s proposed $1-billion austerity plan.

Both houses of the Legislature left committees behind in the Capitol to study the lame-duck governor’s plan. Leaders acknowledged that no action on the budget was contemplated until after Gov.-elect Pete Wilson takes office in January.

“I don’t want to do it piecemeal,” Vasconcellos said.

The assemblyman said it made more sense for lawmakers to act on a projected $800-million deficit in the current year’s budget at the same time the Legislature is looking at how to extricate the state from a possible $4.9-billion shortfall next fiscal year, which begins July 1.

The Senate recessed until Jan. 7, the day Wilson will be sworn in. The Assembly recessed until Assembly Speaker Willie Brown (D-San Francisco) calls them back to town. In all likelihood, that will be Jan. 7.

Times staff writer Daniel M. Weintraub contributed to this story.

BACKGROUND

The unitary tax was established in California more than 50 years ago to make sure that multinational corporations paid their fair share of taxes to the state. Using a complex formula, a company’s taxes are based on a share of its total income worldwide. The British conglomerate Barclays Bank challenged the tax as being unconstitutional after the state Franchise Tax Board determined that the company owed an additional $154,098 for 1977. The company won in Superior Court in Sacramento and won again after the tax board appealed.