Refunds of Illegal Sales Tax Contribute to Budget Woes : Revenue: State and local governments must repay U.S. at least $800 million collected from aerospace contractors.
In the midst of rampant revenue shortages and budget shortfalls, the state and more than 150 California cities and counties will lose hundreds of millions of dollars in sales tax revenues that, state courts have ruled, were illegally collected from aerospace firms.
The money, which will amount to at least $800 million, will be reimbursed to the federal government, which paid sales taxes as part of defense contracts with more than 300 aerospace firms.
The refunds, plus interest, stem from a little-noticed case brought more than 10 years ago by the Aerospace Corp. of El Segundo, contending that it was a violation of federal contracts to tax purchases made in connection with work performed for the Department of Defense.
In 1990, a state Court of Appeal ruled in favor of Aerospace, opening the way for hundreds of other claims. The Department of Defense has ordered all of its California aerospace contractors to file claims so the federal government can recover the funds, company spokesmen say.
The $800-million total could double if a federal court decides in a pending lawsuit that the statute of limitations on refunds should be extended, state officials said.
The Board of Equalization, which has so far processed only about 10% of the claims, has billed 145 cities, 21 counties and seven transit authorities a total of $32.2 million. Board officials expect the job, which they described as an “auditing nightmare,” to be completed in a year.
Many of the affected cities have no major aerospace contractors in their jurisdictions, just vendors that charged contractors sales tax on overhead items such as toilet paper and light bulbs, state officials say.
The magnitude of the refunds--which will be paid by taking the money out of future quarterly sales tax payments to the cities and to the state--has been alarming even to tax officials, said Board of Equalization member Matthew Fong.
“It’s gone beyond the point of potential danger,” he said. “There are 60 cities throughout the state who are in grave danger of having to make big refunds, with no additional sources of revenue to pay for them.”
The largest sum will come from the state, which must pay almost five of every six cents refunded, potentially more than $1 billion. The state, with a $3-billion deficit projected for this year and a similar shortfall expected next year, has already paid $23.4 million in refunds.
The damage to the state’s $56-billion budget has so far been offset by a sales tax increase this year of 1.25%, officials said. After early estimates that the state would lose only $100 million, budget analysts now project that the losses could come to $585 million over the next two years.
“We looked into it and it escalated,” said Connie Squires, a Department of Finance budget analyst, conceding that figure could still rise more. Recent Board of Equalization estimates place the figure at more than $650 million. The remainder of the $800 million would come from localities.
Bill Livingstone, a spokesman for Gov. Pete Wilson, said the sales tax refunds were part of an overall pattern of shrinking revenues. “There are not many places to cut any more,” Livingstone said. “All the easy cuts were made long ago.”
Preliminary audits show that even more painful blows on a proportional basis may be absorbed by small cities, where dozens of firms sold supplies to major aerospace companies. Some could lose the equivalent of three-quarters of their annual sales tax revenue for one year, Board of Equalization officials say.
Most of the affected cities are in the Los Angeles area, the Silicon Valley and the San Diego area, officials said.
The biggest single bite from a local agency has come from the Los Angeles County Transportation Commission, which has given up about $2.3 million so far this year, most of it to pay a claim on behalf of Lockheed. Both Los Angeles County and the city of Los Angeles have paid almost $1 million in refunds.
With 90% of the claims yet to be processed, even higher losses could result, officials said.
One of the hardest-hit cities is Burbank, which saw $654,344 withheld from its quarterly sales tax payments this year as its share of a Lockheed claim. “Add that to the balance of recession effects and the impact was dramatic,” said John Nicoll, Burbank’s director of management services.
Because of revenue losses and the refund, the city has had to leave 50 job vacancies unfilled, Nicoll said.
Beverly Hills, which has no aerospace industry within its city limits, has still had to pay $19,061 in refunds. “They probably have some paper supplier who’s selling to the aerospace contractors,” said one state official.
Preliminary audits of several claims indicate that Pico Rivera, the site of a large Northrop Corp. plant and dozens of small firms that sell supplies to the plant, must repay $3.5 million. Pico Rivera, whose annual general fund budget is about $16 million, already faces a budget shortfall next year of more than $2 million, City Manager Dennis Courtemarche said.
“This is probably the single greatest matter of concern to this city ever,” Courtemarche said.
Hawthorne, with an annual budget of $39 million, could owe $3 million to satisfy claims from Northrop, TRW and Rockwell, state sources said. Redondo Beach, with a budget of $33.6 million, could owe $2.7 million, the sources said.
“It couldn’t come at a worse time,” said Ken Simmons, Redondo Beach assistant city manager. “In the last year and a half we’ve had to drop the budget by $2.5 million, and we’ve lost 40 workers.”
The tax board’s Fong warned that many cities without aerospace contractors have not paid sufficient attention to the problem. “You don’t have to have a major aerospace contractor, you just have to have a lot of companies doing business with aerospace contractors,” Fong said.
Aerospace Corp. took the case to court in the late 1970s, citing a clause in defense contracts giving the federal government ownership of materials at the moment of purchase. By charging sales tax--in most cases, 5% to the state and 1% to the localities where the supplies were purchased--the state was in effect taxing the federal government, which the state has no power to do, the company argued.
The state’s position was that overhead materials should be taxed because they were “consumable supplies” that could not be tied solely to a federal contract, said Board of Equalization assistant chief counsel Gary Jugum. The purchase of a light bulb should be taxed the same as any other purchase, the state argued.
In March, 1990, the appeals court ruled in favor of Aerospace Corp., and three months later, the state Supreme Court let the ruling stand, and the decision has not been appealed to the federal courts.
The Department of Defense has been the prime mover in the claims process, said Martin Louy, tax manager for GenCorp Inc., the Ohio-based parent company of Aerojet ElectroSystems Co. in Azusa.
“The Defense Department’s position is that contractors are obligated in all cases to obtain the refunds,” which are then turned over to the federal government, Louy said. He is chairman of a coalition of the state’s 10 largest defense contractors that are pursuing the refunds.
Adding to the concerns of the affected cities and counties is a court action filed by the federal government, asking that the statute of limitations on refunds be extended from the state’s three-year limit to the federal government’s six-year limit.
The U.S. 9th Circuit Court of Appeals ruled in favor of the state last year on a technicality, but the Justice Department is considering an appeal to the U.S. Supreme Court, Jugum said.
As they become aware of the impending losses, city officials are expressing dismay and frustration at the prospect of losing a major chunk of sales tax revenue in hard times. “This problem is really through no fault of our own,” said Pico Rivera’s Courtemarche. “We’ve done nothing wrong. We received in good faith what we thought was legitimately ours. Now in one fell swoop, it looks as if it will all be taken away from us.”
Twelve cities and representatives of the League of California Cities recently established a task force to consider options, such as state legislation or court actions, to protect themselves. They expect their numbers to grow as the alarming size of the refunds becomes known.
“What we have is a problem where the Board of Equalization apparently misinterpreted the law,” said Don Harrison, a leader of the task force and assistant city manager for El Segundo, where financial officials are predicting a total loss of between $2 million and $6 million in refunds. “Now they’re asking the cities to pay it all back in two years. It’s just not practical.”
Fong said that he has discussed with state legislators a possible bill permitting the cities to extend the payment schedule beyond two years. “It could work like a credit card, with the state covering the cities, who would pay the refunds over time along with interest,” Fong said.
