State’s Unitary Tax Upheld by Supreme Court

The Supreme Court on Monday upheld California’s use of the so-called unitary taxing method for multinational corporations, a decision that spares the state from paying refunds that could have amounted to nearly $2 billion.

But the 7-2 ruling came a year after the state essentially abandoned the taxing approach, which had caused irritation in foreign capitals.

For all the complexity of the legal arguments that have surrounded unitary taxation for more than a decade, the Supreme Court came to a surprisingly simple conclusion: Congress has the power to limit the tax policies of the 50 states, not the President or the federal courts. Congress could outlaw the unitary tax but has refused to do so, the court said.

As the justices pointed out, the Constitution gives Congress the authority “to regulate commerce with foreign nations and among the several states.” Over two centuries, much has been read into that short phrase, including the notion that discrimination against interstate or foreign commerce is forbidden.

But when faced with the question of whether California could calculate its state taxes on multinational firms by a different method than is used elsewhere, the justices fell back on the original language of the Constitution.

“We leave it to Congress--whose voice, in this area, is the nation’s--to evaluate whether the national interest is best served by tax uniformity, or state autonomy,” wrote Justice Ruth Bader Ginsburg for the court. “This court has no constitutional authority to make the policy judgments essential to regulating foreign commerce and conducting foreign affairs.”

The ruling spares Gov. Pete Wilson and the state Legislature a major headache. If the ruling had gone the other way and the unitary tax had been struck down, firms that operate both in California and abroad could have sought refunds dating back into the 1970s.

The ruling was also a victory of sorts for the Clinton Administration. During his 1992 campaign, then-candidate Bill Clinton promised to take a “pro-California” approach in the pending litigation over unitary taxes.

Officials of previous Republican administrations had sided with the multinational firms in urging the courts to invalidate California’s policy as disruptive to international trade.

Brad Sherman, chairman of the state Franchise Tax Board, had lobbied Clinton on the issue and in January of this year the Administration’s lawyers urged the Supreme Court to uphold California’s policy.

Most states and nations, including the U.S. government, calculate taxes based on what is called the separate-accounting method. The local branches of a multinational firm are treated as a separate company. For example, under this approach, the California operations of a Japanese auto maker would be treated as a distinct company and taxed based on the profits reported by this operation.

But California’s tax officials had argued that the approach allows for accounting tricks that hide profits. The foreign auto maker can inflate the cost of a finished car shipped to its California subsidiary. This can allow the subsidiary to report no profits earned in California.

To combat such tax sheltering, California officials adopted the so-called unitary approach under which a multinational firm is treated as a single business. The state gathers data on the percentage of the firm’s payroll, sales and property that are in California. For example, if 4% of a foreign firm’s payroll, sales and property are in California, the state then assumed 4% of its profits were earned in California. That amount was then subject to state taxes.

But European and Asian officials complained that the unitary approach can be unfair because payroll costs are high and property is expensive in California. This inflates the state’s share of profits, they said.

These complaints found a receptive ear among officials of the Ronald Reagan Administration during the 1980s. Under pressure from Washington, the state Legislature in 1986 agreed to allow multinational firms to opt out and use instead the separate-accounting method.

However, they charged a fee to pay for the state’s extra costs of reviewing the tax returns. Last year, believing the unitary method was hurting California’s business climate, the Legislature essentially repealed the taxing method.

Despite this action, the Supreme Court announced last year it would hear appeals from British-owned Barclays Bank as an example of a foreign firm with a California subsidiary. It also considered a second appeal from New York-based Colgate-Palmolive Co. as an example of a domestic firm that operates in the state and overseas.

Initially, the state Franchise Tax Board estimated it could face refunds of up $4 billion if the court ruled against California in both cases. But recently, it revised that estimate downward to between $1.5 billion and $1.9 billion.

Justices Sandra Day O’Connor and Clarence Thomas dissented in the case (Barclays Bank vs. California, 92-1384).