What We Can Learn From the State’s Unitary Tax Fiasco

About $125 for every man, woman and child in the state.

Those are the stakes when the Supreme Court ultimately decides whether California ever had the right to tax multinational corporations based on their worldwide earnings.

What’s not at stake is whether California will continue to apply this “unitary” taxing method in the future, because the state has already abandoned it unless a company actually prefers the method. No one intends to bring it back, either.

In this there is a lesson, one that recent hard times have driven home with the kind of blind repetition that should enable us to recite it in our sleep. The lesson is that the world is not of California’s making, as much as our freeways and mini-malls and movie images have replicated themselves like cultural kudzu all over the known world.

Eighth-largest economy notwithstanding, nowadays we’re the ones who have to adjust. The collapse of Southern California real estate teaches as much. So does the shrinking of the region’s aerospace industry, the persistent high unemployment and the general souring of paradise that many of us feel.

But hardly anything underscores the lesson in business terms as effectively as the story of California’s attempt to tax multinational corporations. The U.S. Supreme Court on Monday kept class in session awhile longer by asking for the solicitor general’s views before deciding whether to consider a key unitary-tax case.

Britain, meanwhile, is threatening retaliation by canceling a tax break given to U.S. companies on the dividends they receive from their British subsidiaries. And unlike the Reagan and Bush Administrations, which opposed California, the Clinton Administration so far has been silent.

Although California has given up its attempt to tax multinationals more effectively, the costs of defeat in court would still be high. If this state loses Barclay’s Bank International vs. California Franchise Tax Board (and a second, related case), it will have to refund $533 million in taxes paid and forgo another $354 million it had hoped to collect. Worse yet, a Barclay’s victory would open the door to a similar case brought by a domestic company, Colgate-Palmolive, which has operations overseas.

All in all, the stakes are about $4 billion, at a time when the state budget is already several billion dollars in the red.

California’s real problem here is that it hasn’t adjusted. When California gave up forcing companies to pay tax on a proportion of worldwide earnings, it decided instead to give firms the option of being taxed according to the more standard “water’s edge” system, which counts only U.S. operations and specified tax havens.

Naturally enough, businesses almost always choose the method that gives them the lowest possible tax.

If California just said to heck with unitary taxation and forced water’s edge on everybody--the way it works in most of the rest of the world--the state would take in an extra $150 million a year, according to Brad Sherman, a member of the Franchise Tax Board, which collects what amounts to California’s corporate income tax. (Sherman is also chairman of the state Board of Equalization, which collects sales and other taxes.)

The whole tangled mess began innocently enough. In 1966, when California was a very different place, it breezily adopted legislation permitting the state to determine a company’s California taxable income based on a proportion of total earnings, wherever they occur. The idea was to tote up worldwide profit, multiply by the proportion of property, payroll and sales that happen to be in California, and voila. In the early 1970s, California started applying this rule to foreign companies as well.

The reasoning was sound. The growth of multinational corporations made it harder and harder to figure out what should be taxed. The so-called unitary system removed the opportunity, to say nothing of the incentive, for multinational accountants to shift earnings to low-tax venues.

Several states adopted unitary taxing systems for corporate profits, but domestic as well as foreign-based corporations fought such plans, and the U.S. Treasury, under pressure from foreign governments that do not use such systems, opposed them.

Concerned about driving out business, most states gave up the idea of mandatory unitary accounting, as did California, which now lets corporations opt out for a fee. Those fees aren’t much, but they still bring in $40 million a year, which also has the British riled.

California has already given up on unitary taxation, and whether it gets to keep the money it collected in the past under the system is up to the U.S. Supreme Court. But whatever the court decides, California is no longer an island on the land. It can’t just go its own way. The consolation is that in this, it is hardly alone.