Court Deals Blow on Budget

California’s budget deficit appeared to grow by about $650 million Monday, after the U.S. Supreme Court refused to review a ruling that state corporate tax laws impede interstate commerce.

The move was more bad budget news for Gov. Arnold Schwarzenegger and state lawmakers, coming less than a week after nonpartisan Legislative Analyst Elizabeth G. Hill warned that the state’s economy is improving more slowly than expected, causing revenue projections to drop by more than $1 billion.

“Not the way you want to start your workweek,” said state Department of Finance spokesman H.D. Palmer. “There is no question this is a substantial hit.”

The latest setback is the result of a state law that allowed corporations to deduct from their taxes dividends received from other corporations, as long as those dividends were paid from corporate income that was taxed by California.

The deduction originally was created to provide an incentive for California firms to invest in other companies in the state without being penalized with double taxation.

State courts ruled that the provision violated federal laws regulating interstate commerce. The ruling will force California to provide refunds and interest to affected corporations.

According to the Franchise Tax Board, the state will have to pay $800 million in refunds to between 1,000 and 2,000 corporate taxpayers with dividend income from out of state.

That would include some of the largest corporations doing business in California, such as Microsoft Corp. and Hewlett-Packard Co.

But because the board is considering jettisoning the dividend tax break, the revenue loss could be offset by $150 million in new taxes the state could collect from companies that had been receiving the break since 2000, said board spokeswoman Denise Azimi. Those same companies could in the future face a new, ongoing obligation of about $35 million a year, she added.

Schwarzenegger administration officials say they have not made any decisions about how to free up the money to make the refunds.

“We’re going to have to account for it when we present our revised [2004-05] budget in the spring,” Palmer said. Among the options are cutting other programs, or siphoning off some of the $15-billion bond revenue that Schwarzenegger is asking voters to authorize on the March 2 ballot, to help pay down past state shortfalls that come due in July.

According to Palmer, the state will not have to pay the entire $650-million bill in one year. It is likely that the refunds will go out over at least the next two years, and possibly longer.

The expected refunds stem from a state appeals court decision in a case brought by Farmer Bros. Co., a Torrance-based coffee roaster and packager. Farmer Bros. sued the state, saying the law discriminated by providing “a deduction for income generated in California but not for income generated from other states,” Thomas Steele, an attorney for Farmer Bros., said Monday. He said his client should receive an $800,000 refund.

Steele warned, however, that he expects the Franchise Tax Board to adopt a tough new stance, declaring all future dividends as taxable income for all firms, whether the investments are in companies that do business in numerous states or just California. The state has taken the position that it intends to level the playing field by treating the 75-year-old dividend law as voided by the state appeals court ruling, Steele said. “They haven’t formally said it, but they’ve indicated in their filings that they would eliminate the deduction for any kind of commerce,” he said.

While spokeswoman Azimi said the board’s legal staff is “studying” the matter, others closely involved say privately that the board intends to take action to eliminate all such deductions in the coming days.

The state has precedent for deciding that the appellate court ruling invalidates state laws that provide the California-only tax breaks on dividends, said Lenny Goldberg, a public interest lobbyist who specializes in tax legislation and policy.

He noted that the board made a similar ruling that California-based insurance companies could not deduct dividends received from California-based subsidiaries. The ruling followed a Dec. 21, 2000, decision by the California Court of Appeal known as Ceridian that found the state to be violating the interstate commerce clause of the U.S. Constitution.

Insurance companies countered by pushing a bill in the Legislature that would have restored some of the deductions for dividend income. The measure is currently stalled in the state Senate Revenue and Taxation Committee.

The Ceridian and, now, Farmer Bros. cases should force the Legislature to “finally do some cleaning up of loopholes and special exemptions” granted industries over the years, said Goldberg, who is executive director of the California Tax Reform Assn. “The state can hardly afford continued erosion of the tax base,” he said. “We’re going to have to figure out some way to get at least some short-term replacement revenues.”

Both the Franchise Tax Board and the Legislature are likely to take a close look at proposals to widen corporate loopholes, said Steele, the attorney for Farmer Bros. “In this budgetary climate, it’s anybody’s guess how the Legislature will move,” he said. Nevertheless, he suggested that businesses might attempt to move a “revenue neutral” bill that would reduce deductions for California-only dividend income, while increasing breaks for dividends from companies operating outside the state.

*

(BEGIN TEXT OF INFOBOX)

Several Factors Could Increase Budget Deficit

With a U.S. Supreme Court action Monday, California must give back $650 million in tax revenue collected from out-of-state corporations.

Although it is unclear when the money must be returned, nonpartisan Legislative Analyst Elizabeth G. Hill noted the case in a report last week and warned that refunds were only one of several “imminent threats” to Gov. Arnold Schwarzenegger’s 2004-05 budget -- apart from whether voters approve a $15-billion bond March 2 to clear up prior-year debts.

Altogether, she said, if several optimistic revenue projections fall short, next fiscal year’s budget deficit could rise by as much as $4 billion:

* The governor is proposing a $930-million bond sale to cover the state’s payment to a pension fund for government workers. A Superior Court has already blocked a similar bond as unconstitutional.

* A 5% cut to the rate paid doctors in the Medi-Cal program was struck down by a judge just before Christmas. The governor has proposed cutting those rates an additional 10%. If all the cuts are found to be illegal, the deficit in the governor’s budget could grow by as much as $1 billion.

* The governor’s budget assumes a $350-million increase in federal aid. There is no sign Washington plans to give the state such a boost.

* Analysts are skeptical the state will be able to generate the $500 million in new Indian gaming revenue that the budget anticipates. Gaming tribes are under no obligation to renegotiate their compacts.

* The budget assumes $400 million can be saved by cuts in the state prison system, but offers no indication of how.