California Insurance Company DRD Provision Ruled Unconstitutional

In a widely anticipated decision, a court of appeal ruled that California's dividends-received deduction (DRD) for dividends received from insurance companies is unconstitutional, because it discriminates against interstate commerce in violation of the Commerce Clause (Ceridian Corp., 102 Cal. Rptr. 2d 611 (Ct. App. 2000)). The court ruled further that a taxpayer may claim a refund of taxes paid under the unconstitutional taxing scheme. Although this ruling is applicable only to dividends received from insurance companies, it supports the widely held view that California's standard DRD provision (which contains similar language) is also unconstitutional. Both provisions limit the DRD based on the extent to which a payor's income is subject to California tax.

The insurance company DRD places two limits on the deduction that a California taxpayer receiving dividends from an insurance company can take (Cal. Rev. & Tax. Code 24410). The first restriction (which the Franchise Tax Board (FTB) conceded as unconstitutional) allows a deduction only if the dividend recipient is commercially domiciled in California. This provision has no counterpart under the non-insurance-company DRD statute.

The second restriction limits the deduction to the portion of the dividend distribution that an insurance company pays out of its California-source income, which the company determines by measuring its property, payroll and sales attributable to California. Under this provision, the more California property, payroll and sales attributable to an insurance company, the greater the dividend recipient's DRD. The court found that this limit discriminates against interstate commerce, because it encourages California taxpayers to invest in insurance companies based on their level of activity in California. The FTB argued that the provision was not discriminatory; but it was designed to avoid double taxation of income earned by and subsequently distributed to California taxpayers. However, the court rejected this argument, explaining that, while the DRD mitigates double taxation, the provision still rewards investments in California companies and, therefore, is discriminatory.

The FTB did not try to argue that the insurance DRD was valid as a compensatory tax. The U.S. Supreme Court has held that, while discriminatory tax provisions are virtually per se invalid, an otherwise discriminatory tax provision may survive a Commerce Clause challenge if it is a valid compensatory tax, designed to make interstate commerce bear a burden already borne by intrastate commerce; see Associated Indus. of Mo. v. Lohman, 511 US 641 (1994).

California's non-insurance-company DRD similarly limits a taxpayer's ability to deduct dividends declared from income included in calculating California taxes (Cal. Rev. & Tax. Code 24402). The court specifically noted that 24402 was not at issue and, thus, expressed no opinion on its constitutionality. However, since 24402 and 24410 produce the same effect, this decision implies that the courts could overrule the 24402 DRD limit as well. The 24402 DRD is currently being challenged; however, this challenge is in the early stages of litigation.

From Sharlene E. Amitay, J.D., CPA, Washington, DC