State & Local Tax Bulletin (February 2000)
California's Interest Offset Provision
By Jeffrey M. Vesely, a tax partner and
Nielsen, of counsel in the
San Francisco office of Pillsbury Winthrop
Shaw Pittman LLP.
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The U.S. Supreme Court has held that California's interest offset provision contained in California Revenue and Taxation Code section 24344, which limits interest expense deductions for corporations, impermissibly allowed California to tax indirectly a corporation's nonunitary dividend and interest income which California could not tax directly. In Hunt Wesson, Inc. v. Franchise Tax Board of California (No. 98-2043) ___ U.S. ___ (2000), the Court held that California's rules authorizing a deduction for interest expense but only to the extent that the amount exceeds certain out-of-state income arising from the unrelated business activity of a discrete business enterprise, i.e., income that the State could not otherwise tax, violated the U.S. Constitution's Due Process and Commerce Clauses. The Court observed that in other contexts the federal government and other states employed reasonable efforts to properly allocate a deduction between taxable and nontaxable income. The Court concluded that California's interest offset rule was not a reasonable attempt at allocation.
The case was remanded to the trial court for further proceedings consistent with the Court's opinion. The Franchise Tax Board at oral argument indicated that the Revenue and Taxation Code already provides alternative methods to allocate expenses between taxable and nontaxable income. For example, Revenue and Taxation Code section 24425 disallows the deduction for expenses that are allocable to one or more classes of income not included in the measure of the tax. In Appeal of Zenith National Insurance Company, No. 98-SBE-001, January 8, 1998, a case handled by Pillsbury Madison & Sutro LLP, the taxpayer successfully overcame the application of the Franchise Tax Board's general asset allocation formula and proved that certain interest expense was incurred for the purpose of producing taxable income and, thus, the taxpayer was able to claim the full interest deduction. In anticipation of their defeat in Hunt-Wesson, the Franchise Tax Board on audit has been performing calculations under both Section 24344 and an alternative asset allocation formula, such as that which was put forth in Zenith.
Taxpayers should review the impact of interest offset on past filings as well as on their 1999 return and file refund claims if appropriate.
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