WASHINGTON -- The Supreme Court yesterday invalidated Iowa's corporate income tax because the levy unconstitutionally discriminates against foreign commerce.

The court's 7-to-2 ruling in Kraft General Foods Inc. v. Iowa Department of Revenue and Finance was hailed by business groups, but could make it more difficult for at least nine other cash-strapped state governments to bolster their treasuries.

"I'm most pleased," said Amy Eisenstadt, tax counsel for the Committee on State Taxation of the Council of State Chambers of Commerce. "The ruling calls into question the tax systems of a number of states."

Iowa's business tax piggybacks on the federal tax code's definition of "net income." Consequently, the state allows corporations to take deductions for dividends received from domestic subsidiaries, but does not allow deductions for dividends paid by foreign subsidiaries.

Five states in addition to Iowa include foreign subsidiary dividends in their tax bases while excluding dividends from domestic subsidiries. Four other states allow partial exemptions for foreign subsidiary dividends that are less than those allowed for domestic subsidiaries.

"We're disappointed," said Carl Castelda, deputy director for the Iowa Department of Revenue.

Mr. Castelda said the state stands to lose $8 million a year in revenues as a result of the decision.

He said the state's legal counsel will analyze the case to determine whether the state is required to pay $20 million to $25 million in tax refunds to businesses in accordance with a three-year statute of limitations.

The Supreme Court ruling came as a blow to the state, which is in the midst of a stalemate between Gov. Terry Branstad and legislators over resolution of the fiscal 1993 budget.

State Treasurer Michael Fitzgerald said the loss of $8 million will increase the state's $338 million deficit as measured on a generally accepted accounting principles basis.

"On a budget basis, there is certainly no room to spare. It continues to add to financial crisis in our state," Mr. Fitzgerald said.

Earlier this month, the governor balanced the state's $3.47 billion budget with line-item vetoes of $391 million in spending, including $276 million for Medicaid programs. The governor is expected to call a special session to ensure funding for Medicaid and other programs before July 1 the start of fiscal 1993.

The budget logjam also has held up a $400 million tax anticipation note issue that had been scheduled to be sold July 1 to finance school aid payments and other expenditures.

The scramble to balance the budget began when Gov. Branstad vetoed a one-cent sales tax increase that would have generated an estimated $272 million in fiscal 1993 and enabled the state to set aside $60 million for reducing its $338 million GAAP deficit.

In yesterday's case, Kraft, maker of processed cheese products, unsuccessfully challenged the differential treatment of dividend income in Iowa courts. But yesterday, the Supreme Court said Iowa's statute violates the Constitution's foreign commerce clause.

Justice John Paul Stevens, writing for the court majority, made short shrift of an argument made by lawyers for both Iowa and the United States that Kraft could conduct foreign business through domestic, rather than foreign, subsidiaries to avoid taxation of the dividends. The United States entered the case as a friend-of-the-court on Iowa's behalf.

"Whether or not the suggested methods of tax avoidance would be practical as a business matter, and whether or not they might generate adverse the consequences in other jurisdictions, we do not think that a state can force a taxpayer to conduct its foreign business through a domestic subsidiary in order to avoid discriminatory taxation of foreign commerce," Justice Stevens said.

"We find no authority for the- ... proposition advanced here that a tax that does discriminate against foreign commerce may be upheld if a taxpayer could avoid that discrimination by changing the domicile of the corporations through which it conducts its business," he added. "Our cases suggest the contrary."

Chief Justice William H. Rehnquist, joined by Justice Harry A. Blackmun, dissented, saying that Kraft had failed to show that "no set of circumstances exists under which the act would be valid."

Ferdinand P. Schoettle, a professor at the University of Minnesota Law School, said the ruling provides needed protections to multinational businesses.

"These are hard problems," he said. "The multi-nationals for a variety of reasons have divided themselves into so many units -- with large flows of money between subsidiaries and parents -- that taxation of those flows can get very complicated."

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