California's Deduction For Dividends Received From Insurance Companies Held Unconstitutional

California courts have dealt another blow to California's treatment of intercompany dividends. In Ceridian Corp. v. Franchise Tax Board, S.F. Superior Court No. 98377 (tentative decision dated May 7, 1998), a California trial court struck down section 24410 of California's Revenue and Taxation Code, which allows corporations domiciled in the state to deduct dividends received from insurance company subsidiaries but (i) only if the corporation receiving the dividend is domiciled in California, and (ii) only to the extent the dividends were paid from California-source income. This taxpayer victory follows on the heels of Hunt-Wesson, Inc. v. Franchise Tax Board, S.F. Superior Court No. 976626 (June 6, 1997), which declared California's interest offset provision, Rev. & Tax. Code § 24344(b), unconstitutional and is currently being appealed. The interest offset provision reduces a taxpayer's business interest deduction by the amount of the taxpayer's nonbusiness interest and dividend income, effectively taxing on an apportioned basis the nonbusiness income of nondomiciliary taxpayers, and thus discriminating against interstate commerce.

Rev. & Tax. Code § 24410 discriminates against interstate commerce on two levels. First, it allows deductions only to corporations domiciled in California. The Ceridian court quickly dispensed with this portion of the statute, declaring it facially discriminatory. Of more interest was the second limitation on a corporation's deduction, namely the limitation of the deduction to the portion of the dividend attributable to business activity within California. As a result of this limitation, only dividends from insurance companies whose operations were confined to California were 100% deductible. By contrast, corporations like Ceridian, with insurance subsidiaries engaged in business within and without California, could deduct only a portion of the dividends. In Ceridian, the court permitted the nondomiciliary dividend payee a full deduction for dividends received without regard to the amount of business done by the insurance company in California.

Rev. & Tax. Code § 24110 closely resembles the statute unanimously struck down by the United States Supreme Court in Fulton v. Faulkner, 516 U.S. 325 (1996). The statute challenged in Fulton levied an intangibles tax on stock owned by North Carolina taxpayers but allowed a deduction proportional to the percentage of the corporation's income apportioned to North Carolina. The statutes in Fulton and Ceridian could have been upheld had it been shown that the tax burdens they placed on interstate commerce properly compensated for tax burdens borne by intrastate commerce. In Ceridian, however, the Franchise Tax Board ("FTB") failed even to identify the intrastate tax burden for which the provision was meant to compensate or to show that the events on which the intrastate and interstate taxes were imposed were similar. Thus, as in Fulton, the compensatory tax doctrine did not save the statute in Ceridian.

In light of the fact that section 24410 was widely believed to be unconstitutional, particularly after Fulton, many observers were fairly confident a court would invalidate it. Observers may have had more difficulty predicting whether the court would allow the taxpayer a full refund based upon a deduction of 100% of the dividend. The FTB attempted to deny a refund by arguing that retroactively increasing taxes on Ceridian's competitors by denying them the dividends received deduction would provide the "meaningful backward-looking relief" required by the U.S. Supreme Court in McKesson Corp. v. Division of Alcoholic Beverages & Tobacco, 496 U.S. 18 (1990), among other cases. The court rejected the FTB's argument, pointing out that if the statute of limitations prevented the FTB from collecting back taxes, Ceridian's victory would ring hollow. Instead the court ordered the FTB to refund the taxes improperly collected under the statute.

The FTB almost certainly will appeal the trial court's decision, and we are optimistic about the taxpayer's prospects on appeal. Assuming the Court of Appeal affirms the trial court, Ceridian bodes well for challenges to Rev. & Tax. Code § 24402, a dividends received deduction with much broader applicability. That section permits a deduction for dividends received by any corporate taxpayer from any corporation but only to the extent of the dividend payor's presence in California. Importantly, because of section 24402's broad applicability, the Ceridian court's choice of relief (i.e., a refund based upon deducting 100% of the dividend) could cause the state to make substantial refunds to California taxpayers. Though we are not aware of any section 24402 challenges currently pending in the state's courts, we certainly expect taxpayers to bring such challenges soon.

This newsletter addresses recent state and local tax developments. Because of its generality, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.