State Justices Hear U.S. Challenge to Unitary Tax

The Bush Administration on Tuesday asked the California Supreme Court to strike down a method used to tax foreign multinational corporations--an action officials warn could cost the state’s dwindling treasury nearly $800 million in revenue.

The court, hearing arguments in Los Angeles, was told by a lawyer for the U.S. Department of Justice that the state’s so-called “unitary tax” interferes with the federal government’s conduct of foreign policy and invites retaliation by the nation’s trading partners.

“The tax impairs the United States’ ability to speak with one voice in foreign affairs,” John J. McCarthy, an attorney for the department’s tax division, told the justices. “There are very, very serious implications of foreign policy involved.”

A lawyer for California countered that the tax was permissible because the Constitution gives Congress, rather than the executive branch, power over foreign commerce--and Congress has refused to bar states from using the unitary tax.

“This is a totally legitimate method of taxation,” said state Assistant Atty. Gen. Timothy G. Laddish. “The burdens (on multinational corporations) are not that great.”

The case has attracted wide interest in the international business community, with Britain, Japan and several other governments supporting a constitutional challenge to the California tax. A ruling is due within 90 days.

Under the system, the state has long collected income tax from multinationals based on the proportion of their worldwide property, payroll and sales activity in California. Most other states base their taxes on only the profits reported within the state--a method also followed by the United States and all other nations. California maintains that this alternative system allows companies to shift profits among subsidiaries to avoid taxation.

In the case before the court, Barclays Bank of London, a foreign-based multinational corporation, challenged the tax and sought a refund for 1977, saying the system was burdensome and unfairly permitted multiple taxation. In December, 1990, a state Court of Appeal in Sacramento agreed that the tax was unconstitutional, saying it interfered with the federal government’s ability to conduct foreign affairs.

If the state loses the Barclays case, California stands to lose $792 million in revenue owed or paid under protest before 1988 by foreign firms, according to Laddish. A temporary alternative method has been used since 1988.

The state could lose another $2 billion or more if the court eventually strikes down the unitary tax in a separate, pending case involving U.S. multinational firms, he said. The state currently faces a budget deficit of $3 billion at the end of the fiscal year.

In Tuesday’s hourlong hearing, Laddish argued that Congress had acquiesced to the unitary tax when, in the 1970s, the Senate declined to ratify a treaty negotiated by the United States and Britain until a provision barring the tax was removed. The fact that Congress has not joined in efforts by Presidents Richard M. Nixon, Gerald R. Ford, Jimmy Carter and Ronald Reagan to ban the tax provided more proof the lawmakers implicitly approved it, Laddish said.

Joanne M. Garvey of San Francisco, attorney for Barclays, argued that Congress had failed to act affirmatively on the issue and thus had not clearly asserted its constitutional authority to control foreign commerce.

McCarthy, appearing for the Bush Administration in support of Barclays, noted that Britain had enacted, but not yet enforced, retaliatory measures against companies from states with the unitary tax. Failure to strike down the unitary tax could cause further countermeasures by America’s trading partners, leading to reduced investments at home and abroad, he warned.

“Retaliation would be catastrophic for the commercial affairs of the United States,” McCarthy said. “These days we live in a global economy.”