Brief of Tax Executives Institute, Inc. as amicus curie in support of petitioner

Tax Executive, The, Nov, 1999

Under Allied-Signal, a State may tax dividend income only where the payee and payer of the dividend are engaged in a unitary business or the capital transaction serves an operational -- rather than an investment -- function. 504 U.S. at 787. Here, the State seeks to rationalize its taxation of dividend income by claiming it is closing a so-called loophole, i.e., that a foreign corporation should not be permitted to borrow money and build up its interest expense deduction and then receive tax-exempt dividends on the basis of investments made with the borrowed money. Pacific Telephone, 7 Cal. 3d at 554. A suspiciously similar argument was advanced by the State of New Jersey in the Allied-Signal case. There, in seeking to repudiate the unitary business principle, the State argued that multistate corporations regard all their holdings as asset pools and therefore any distinction between operational and investment assets is artificial and should be ignored. 504 U.S. at 784-85. The Court wisely rejected this strained contention, noting instead that the relevant inquiry must focus on "the objective characteristics of the asset's use and its relation to the taxpayer and its activities within the taxing State." Id. at 785. The dividend income sought to be taxed here bears no relationship to Petitioner's instate activities and thus California's contrived attempt to tax it should be rejected as violating due process.

Moreover, the State's semantics -- that the interest-offset rule is not a "tax" and therefore the precedents of this Court are not controlling -- cannot change the substance of the statute. It is clear that California could not tax Petitioner's dividend income directly. ASARCO Inc., 458 U.S. at 327-29. It is also clear that a State may not, through constitutional alchemy, indirectly tax income beyond its jurisdiction. In Westinghouse Electric Corp. v. Tully, 466 U.S. 388 (1984), the Court clarified that the denial of a tax exemption (or a deduction) is the economic equivalent of a tax:

   Nor is it relevant that New York discriminates against business carried on
   outside the State by disallowing a tax credit rather than by imposing a
   higher tax. The discriminatory economic effect of these two measures would
   be identical.

Id. at 404. See also National Life Ins. Co., 277 U.S. at 520 ("What remains after subtracting all allowances is the thing really taxed.")(11) In other words, formal distinctions lacking in economic substance have no constitutional significance. Westinghouse Electric Corp., 466 U.S. at 405. Thus, "[al tax on sleeping measured by the number of pairs of shoes you have in your closet is a tax on shoes." Trinova Corp. v. Michigan Dep't of Treasury, 498 U.S. 358, 374 (1991) (citation omitted). Cf. Bass, Ratcliff & Gretton, Ltd. v. State Tax Comm'n, 266 U.S. 271, 282-83 (1924) (States' efforts to tax income from non-unitary entities is "a mere effort to reach profits earned elsewhere under the guise of legitimate taxation").

The State characterizes the interest-offset rule as a rational attempt to "correlate expenses between taxable and nontaxable income in order to determine the extent to which a deduction should be allowed." Brief of Franchise Tax Board in Opposition to Petition for Writ of Certiorari, Hunt-Wesson, Inc. v. Franchise Tax Board, No. 98-2043, at 16 (hereinafter cited as "Br. Op."). The State's argument conveniently ignores that non-business interest expense is deducted before the interest-offset rule is applied.(12) What is more, the statute makes no attempt to allocate the business interest expense to related income. Rather, it requires a dollar-for-dollar offset of the expense against nonbusiness income, with no matching of expense to income being permitted.