WASHINGTON - In a major victory for states, the Supreme Court yesterday upheld California's method of taxing foreign and domestic multinational corporations, even though the method is at odds with federal policy.
The 7-to-2 ruling in Barclays Bank v. California is expected to help fiscal 1995 budget preparations by California, which has been relying on a favorable ruling to anticipate added revenue. The decision also paves the way for other states to adopt the potentially lucrative method used by California, the so-called "worldwide combined reporting" method of taxation.
Barclays Bank PLC, which is part of a multinational banking enterprise based in the United Kingdom, and the U.S.-based Colgate-Palmolive Co. had challenged the California corporate income tax law, saying it resulted in multiple taxation and higher tax liability and compliance costs in violation of the Constitution.
The ruling "is clearly a very important victory for the states," said Richard Ruda, general counsel for the State and Local Legal Center, which filed a friend-of-the-court brief on behalf of the Council of State Governments, National League of Cities, and other state and local interests.
"This is also a very important case about federalism," Ruda said. "There is a critical theme in the court's opinions, going back for decades, that states are laboratories of democracy, and our federal system enables states to try out schemes of governance or programs or ideas in the tax area, as well as other areas, that aren't being utilized on a national basis yet. This case perfectly illustrates that point."
Idaho, North Dakota, Tennessee, and Utah provide for some form of worldwide combined reporting requirements. In addition, Alaska, Montana, New Hampshire, and Oregon filed a joint brief saying they use or have used the method.
Under the worldwide combined reporting method, which also is referred to as the worldwide unitary or formulary apportionment method, all of a multinational company's income is lumped together for purposes of deciding what portion should be taxed by a state. The corporate family is broadly defined as a unitary business.
In contrast, the U.S. executive branch advocates the "separate accounting" or "arms length" method, which is codified in numerous tax treaties whit the United Kingdom and other countries. The approach calls for a state to determine what portion of a company's income is earned within the state and to levy a tax on that portion. Transactions between affiliated corporations are scrutinized to ensure they are reported on an arm's-length basis to prevent manipulation of transfers of value among corporate units.
The best method for a state to use to raise revenue depends on the state's fiscal and political situation, said Roxanne Davis, research attorney with the Federation of Tax Administrators, which represents tax officials from all states.
Davis does not see states "in a rush" to make the worldwide combined reporting method mandatory. For example, states may want to protect companies in their jurisdictions from foreign retaliation, or the worldwide combined reporting method may be detrimental to particular domestic multinational companies because of their specific tax situations, she said.
Davis also does not expect Congress to act soon to overturn the ruling, because it has not done so in the past, and because members of Congress are increasingly concerned about imposing unfunded mandates on states.
The United Kingdom adopted retaliatory legislation in 1985, which it has not implemented but has been used as leverage to fight the California law.
Writing for the majority, Justice Ruth Bader Ginsburg said it is up to Congress, not the court, to decide foreign tax policy and to weigh any risk of retaliation by other countries. Congress has had opportunities to set tax policy in this area, but it has not specifically done so, she said.
In addition, the worldwide combined reporting method does not raise any greater risk of multiple taxation than other schemes, she said.
"The history of Senate action on [the] United States/United Kingdom tax treaty ... reinforces our conclusion that Congress implicitly has permitted the states to use the worldwide combined reporting method," the majority said.
California's use of the worldwide combined reporting method does not violate either the Constitution's commerce clause or due process rights, as Barclays and Colgate argued, the court said.
The commerce clause prohibits states from erecting barriers to interstate commerce. When applied to foreign commerce, the clause further constrains states form hurting the federal government's need to speak with "one voice" in its commercial relations with foreign governments.
The high court's decision "is helpful" to states, but "unfortunately, they didn't go far enough," Davis said.
For example, the decision makes clear that the executive branch cannot preempt state tax law by issuing press releases, writing letters, and filing briefs in court cases. Congress can preempt state tax law, but it must be clear and specific in doing so, the majority held.
However, the court did not address whether the executive branch can preempt state law through executive order or by exercising authority delegated to it under an international agreement subject to congressional ratification, such as the General Agreement on Tariffs and Trade, or GATT, Davis is said.
"However, that's another fight for another day," she said.
As far as the ramifications for California's budget, the decision is likely to help the state's political leadership develop a balanced spending plan for fiscal 1995 and pave the way for the issuance of $5 billion of revenue anticipation warrants next month, state Controller Gray Davis said yesterday.
"Sacramento can now see the light at the end of the tunnel," Davis said. "This should be encouraging news, provided that [legislators] have the backbone to make the hard decisions that unfortunately need to be mad."
The ruling should help the state get a budget completed before the start of the new fiscal year on July 1, said H.D. Palmer, an assistant director for the state department of finance, which is closely aligned with Gov. Pete Wilson.
The opinion "is extremely good news" Palmer said. "It is vindication of California's long-standing belief that what we did was right."
Wilson's proposed spending plan for the 1995 fiscal year included $600 million of revenues based on an assumption that the state would be victorious in the case.
However, an official with the state Board of Equalization said yesterday that Wilson was overly optimistic in predicting the state would receive $600 million of revenues. Board legal counsel Coby King said it is more likely that the state would receive about "half a billion" dollars in revenues next fiscal year. "the exact figure is unclear."
Wilson's budget proposal "is a little out of balance," King said. But he said that the difference is small in comparison with the dramatic impact of a negative court decision. An unfavorable decision could have required tax refunds of $1.5 billion, he said.
The court decision "allows California to dodge a pretty giant bullet," King said. "If we had lost the case, we would have been $2 billion in the hole" - $500 million in lost tax revenues and $1.5 billion of tax refunds.
King said there is no guarantee that the state will collect the roughly $500 million of revenues in fiscal 1995. He said the dollar amount refers to what "various multinationals have owed" California, but declined to pay pending the court resolution. "Since California won those cases, the way is clear for California to collect on those assessments."
A two-house legislative budget-writing conference committee met yesterday in Sacramento to debate Wilson's budget plan, which the governor unveiled on June 13. The legislature missed its constitutional June 15 deadline to pass a budget, but leaders have said a spending plan would be in place before July 1.
Davis, the controller, said the high court's decision is "a terrific break for California."
Last week Davis said that his analysis of Wilson's budget found it had a "$2.4 billion hole" that needed to be filled before it was financially viable. The budget gap would prevent Davis from certifying Wilson's proposed $5 billion revenue anticipation warrant borrowing next month.
The court decision means roughly $500 million in additional revenues have been found, and the Wilson budget "is now $1.9 billion short of where we need to be to repay a $5 billion loan," Davis said.
Davis said he has recommended changes in state law that would allow the state an additional $550 million in internal borrowing capacity, which would lower the budget gap to about $1.3 billion.
While the Supreme Court agreed that California has the right to tax multinational corporations based on their worldwide earnings, the method already has been abandoned by the state in most circumstances. Multinationals now have the choice between paying taxes based on unitary calculations or based on their earnings in the United States.