Metropolitan News-Enterprise


Wednesday, August 29, 2012


Page 1


C.A. Holds Tax Statute Discriminatory and Unconstitutional




The Court of Appeal for this district yesterday held unconstitutional a state tax law that defers payment of capital gains taxes on the sale of stock in some corporations but not others.

Justice Elizabeth Grimes, writing for Div. Two, said subdivisions (c)(2)(A), (e)(1)(A) & (e)(9) of  Revenue and Taxation Code Sec. 18152.5 violate the Commerce Clause.

Those provisions allow an individual taxpayer to defer capital gains on the sale of stock in a qualified small business if the taxpayer used the gain to purchase stock in another qualified small business.  But the only corporations that qualify are those that used 80 percent of their assets in the conduct of business in California and that maintained 80 percent of their payrolls in California.

“Under the teaching of the high court in Fulton Corp. v. Faulkner (1996) 516 U.S. 325, 330… we are bound to and do conclude that, because the statute affords taxpayers a deferral for income received from the sale of stock in corporations maintaining assets and payroll in California, while no deferral is afforded for income from the sale of stock in corporations that maintain assets and payroll elsewhere, the deferral provision discriminates on its face on the basis of an interstate element in violation of the commerce clause,” Grimes wrote.

Stock Sale

The law was challenged by Frank Cutler, an investor and director of several companies. Cutler sold stock in U.S. Web Corporation for nearly $2.3 million in 1998, rolling part of the proceeds over into the stock of several other small companies.

Cutler deferred capital gains from the rolled-over proceeds on his 1998 state tax return, but the Franchise Tax Board rejected the deferral in 2004. Cutler protested unsuccessfully to the board; paid $442,000 in tax, penalties, and interest; lost an appeal to the State Board of Equalization; and sued for a refund.

Los Angeles Superior Court Judge Michael Stern granted the board’s motion for summary judgment, finding the statute constitutional.

Grimes, however, cited a number of cases holding that state tax laws violated the Commerce Clause, including Fulton. That case struck down North Carolina’s “intangibles tax,” levied under a scheme that allowed the taxpayer to take a deduction based on how much of the corporation’s income was subject to tax in the state.

Thus, if a corporation did no business in North Carolina, intangibles tax would be based on the entire value of the taxpayer’s stock, but if a corporation did all of its business in the state, there would be no tax on its stock at all, as the owner would receive a 100 percent deduction.

‘Favors Domestic Corporations’

Such an arrangement “favors domestic corporations over their foreign competitors in raising capital among North Carolina residents and tends, at least, to discourage domestic corporations from plying their trades in interstate commerce,” the Supreme Court held.

That the section at issue in this case concerns a deferral, rather than an exemption or deduction, does not change the analysis, Grimes wrote. The purpose is the same, she said—to encourage investors to put their money in companies doing business in California, to the disadvantage of those doing business elsewhere.

She distinguished Department of Revenue of Ky. v. Davis (2008) 553 U.S. 328, in which the high court upheld the right of a state to exempt interest on its own bonds from state income taxes, while taxing bond income from other states, as is the practice in 42 states.

Davis Explained

The rationale of Davis, Grimes explained, is that in exempting interest on bonds that it issues itself, the state is promoting its own interests as a competitor in the market for investment dollars. Thus, the state is not discriminating against foreign commerce, as California is under Sec. 18152.5, the justice said.

Grimes noted that there were other issues before the board with regard to whether Cutler qualified for the deferral; those will have to be resolved after remand, she said.

Attorneys on appeal were Margaret M. Grignon, Mardiros H. Dakessian and Zareh A. Jaltorossian of Reed Smith for the plaintiff and Deputy Attorney General Stephen Lew for the state.

The case is Cutler v. Franchise Tax Board, B233773.


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