ISSUE: The Legislature last week gutted the state’s unitary tax system in response to objections from foreign governments and international companies. The system is an accounting method to assess the state tax obligation of a multinational company operating here, based on its worldwide operations. Companies that pay a fee can opt out of the system.
Multinational companies and foreign governments have challenged the system as onerous and unconstitutional. The state has defended it as a fair way to make sure multinationals did not shift earnings to other units to avoid taxes.
BACKGROUND: In the 1970s, the state decided to employ the unitary tax system as a way to calculate a multinational company’s California taxes based on the state’s share of the corporation’s worldwide payroll, property and sales. The system required detailed disclosure of such information.
In 1988, the system was changed to allow multinational companies to opt out of it by paying a fee, amounting to a small percentage of total California property, payroll and sales.
The companies would then be liable for state taxes based only on their American operations.
If such firms increased state employment or investment, the fee could be reduced.
Since 1988, the state has collected about $40 million annually in such fees.
However, some 30 foreign-based companies have sued, challenging the tax as unconstitutional and seeking refunds. California’s total potential liability is about $4 billion.
The state Supreme Court--hearing an appeal in a case filed by Britain’s Barclay Bank and its California subsidiary--upheld the tax in 1992, ruling that Congress had repeatedly declined to bar states from imposing such a taxing system, in effect giving them implicit permission to do so.
The case has been appealed to the U.S. Supreme Court. The court has asked the solicitor general to file a brief in the case, but has not yet decided whether to hear it.
Separately, in 1985, Britain threatened to revoke certain tax benefits to U.S. companies doing business in the British Isles unless the unitary tax system was changed. This year, Britain set a deadline of Dec. 31.
OUTLOOK: Over the weekend, as part of a sweeping package of economic stimulus measures, the Legislature voted to eliminate the fee that multinational companies pay to avoid the unitary tax, and also exempted them from disclosure requirements.
The legislation, which Gov. Pete Wilson is expected to sign, appears to address the concerns raised by Britain.
California stands to lose about $40 million a year in fees and $35 million in lower taxes paid by multinational corporations as companies have greater freedom to opt out.
This week, meanwhile, Britain is expected to respond to the state’s action, and state officials hope they will be mollified.
As for the lawsuits, it is unclear how the legislation may affect them. State officials hope the changes will encourage the Clinton Administration to submit a brief to the U.S. Supreme Court backing the state’s position not to hear the Barclay case.
STRATEGY: It’s an open question whether companies will be inclined to invest in the state under the new tax structure. The state’s income taxes remain relatively high, and other factors continue to make it an expensive place to do business.
But multinationals already operating here will find it possible to lower taxes and cut paperwork. And that may be an attraction to foreign companies who are considering investing in the state.