United States Supreme Court Seals Taxpayer Victory in Farmer Bros

On February 23, 2004, the United States Supreme Court rejected the petition for certiorari ("Cert. Petition") filed by the California Franchise Tax Board ("FTB") in Farmer Bros. Co. v. Franchise Tax Board, 108 Cal. App. 4th 976 (2003), cert. denied, No. S117131, 2003 Cal. LEXIS 6515 (Aug. 27, 2003), cert. denied, 124 S. Ct. 1411 (Feb. 23, 2004). Thus, the book is closed on Farmer Bros.' successful challenge to the state's discriminatory dividend received deduction ("DRD") statute, i.e., California Revenue & Taxation Code section 24402.1

In this article, we review the legal principles that framed the controversy and provide some insight into what lies ahead now that the litigation has been successfully concluded. At the outset, we briefly summarize the background of the litigation and the decision of the California Court of Appeal that was the target of the FTB's Cert. Petition. Thereafter, we summarize the grounds raised by the FTB as its basis for seeking U.S. Supreme Court intervention, including, particularly, the FTB's attempt to convince the Court that the discriminatory DRD should be viewed as a complementary tax imposed upon interstate commerce in compensation for other taxes paid solely by intrastate commerce. Next, we provide a brief response to those arguments drawn largely from the Opposition to Cert. Petition brief filed by Farmer Bros. Whether the debate on the substantive issue had any persuasive effect upon the Court in denying the Cert. Petition is, of course, speculation. Nonetheless, the grounds advanced by the FTB in its Cert. Petition raise some interesting issues worth exploring in their own right, because they shed light upon the nature of proof that a state must advance to meet the requirements of complementary tax defense to an otherwise facially discriminatory tax.

Finally, we address the question of remedies. In this regard, it appears that all taxpayers with valid (timely-filed) claims involving tax years prior to 1999 should expect a refund of the discriminatory taxes collected by the State (albeit with a possible adjustment to disallow as a deduction, expenses attributable to the investment which produced the dividend). In contrast, for taxes paid in 1999 and thereafter, the issue remains very much in play: the FTB apparently intends to deny all DRDs that previously relied upon section 24402 as authority on the theory that section 24402 has now been voided in its entirety by the litigation. Thus, the FTB apparently intends to disallow a deduction for all dividends received by corporate taxpayers regardless of whether those dividends are drawn from income taxed by California or income taxed by other states. In this discussion, we outline arguments that may be available to taxpayers to challenge the FTB's position and/or encourage new legislation, including a brief description of the efforts underway to enact legislation to restore the insurance company DRD which was struck down in earlier litigation.

Background of the Litigation

Farmer Bros., a California coffee manufacturer, received dividends from investments in various companies engaged in business in other states as well as, in some cases, in California. Relying upon section 24402, Farmer Bros. Co. took a deduction for up to 70 percent of the dividends based on its stock ownership in the payor corporations. (The deduction was available in greater percentages as the stock ownership percentage increased.) However, section 24402 limited the deduction to dividends considered to have been paid from income that had previously been subject to California tax (which determination depended upon the dividend payor's relative apportionment factors within the state of California).

Farmer Bros. challenged the limitation placed on the section 24402 deduction as violating the Commerce Clause - citing among other things, that the statute provides a tax benefit based upon the relative presence of the payor in the state, in violation of the U.S. Supreme Court's ruling in

Fulton Corp. v. Faulkner, 516 U.S. 325 (1996). The FTB, in turn, countered that the statute did not discriminate against interstate commerce because its purpose was to eliminate double taxation of California income and not to favor in-state commerce. The FTB also argued that the section 24402 scheme, in effect, imposed a "compensatory tax" upon a stream of earnings that originated in other states, and that the imposition of this tax insured that the out-of-state earnings bore a California tax equal to that borne by earnings generated from within the State.

The Court of Appeal Ruling

In holding that the DRD violated the Commerce Clause, the California Court of Appeal relied principally upon three authorities: Fulton, supra, 516 U.S. at 327, which struck down a North Carolina "intangibles tax" that taxed "a fraction of the value of corporate stock owned by North Carolina residents inversely proportional to the corporation's exposure to the State's income tax"; Ceridian Corp. v. Franchise Tax Bd., 85 Cal. App. 4th 875 (2000), which struck down a California dividend received deduction for dividends paid by insurance subsidiaries that was closely similar in concept to the DRD at issue in Farmer Bros.; and D.D.I., Inc. v. North Dakota, 657 N.W.2d 228 (N.D. 2003), which struck down a North Dakota dividends received deduction that apparently mirrored the DRD at issue in Farmer Bros. In reliance upon these authorities, the California court held:

We conclude that section 24402 is discriminatory on its face because it affords to taxpayers a deduction for dividends received from corporations subject to tax in California, while no deduction is afforded for dividends received from corporations not subject to tax in California. As a result, the DRD scheme favors dividend-paying corporations doing business in California and paying California taxes over dividend-paying corporations which do not do business in California and pay no taxes in California. The deduction thus discriminates between transactions on the basis of an interstate element, which is facially discriminatory under the commerce clause. Farmer Bros., 108 Cal. App. 4th at 986-87.

The Court of Appeal also concluded that the DRD violated the "internal consistency doctrine" because, assuming other states replicated California's DRD, the combined tax burden of the dividend payor and the dividend recipient would be greater if the payor and recipient operated in different states than the tax burden would be if the payor and recipient did business wholly within a single state.

The Denial of the DRD Cannot Be Justified as a Compensatory Tax

After concluding that the DRD constituted facial discrimination against interstate commerce, the Court of Appeal rejected the FTB's argument that the discrimination could be justified because the restriction on the DRD operated to compensate for the fact that in-state commerce (i.e., dividends qualifying for the DRD) previously had borne a California franchise tax while interstate commerce (i.e., non-qualifying dividends) had been exempt from that tax burden. The Court of Appeal first noted three conditions that the U.S. Supreme Court has articulated as necessary to invoke the so-called compensatory tax defense: (1) a state must, as a threshold matter, identify the intrastate tax burden for which the state is attempting to compensate; (2) the tax on interstate commerce must be shown roughly to approximate, but not exceed, the amount of the tax on intrastate commerce; and (3) the events on which the interstate and intrastate taxes are imposed must be substantially equivalent; that is...