(This article was originally published by Law360 on April 16, 2019.)
In recent years, many have openly criticized California for its income tax litigating position involving out-of-state companies that hold passive, minority interests in pass-through entities doing business in California. The state argues these out-of-state companies are doing business in California solely by virtue of their passive, minority investment in pass-throughs that conduct business in California. The state has lost the issue twice in the last two years. Most recently in September 2018 before an administrative appellate body in a nonprecedential decision involving a 25% passive ownership interest and the other in 2017 at the California Court of Appeal in a published decision involving a 0.2% passive ownership interest.
This practice is troublesome not only to the impacted out-of-state companies that must file returns and pay California’s annual or minimum tax but potentially to the states where the out-of-state companies are based. In a recent United States Supreme Court filing, Arizona has alleged that California’s “aggressive” nexus assertions and related imposition and collection of its annual and minimum taxes impact Arizona by decreasing the state’s annual revenue every time an Arizona-based company pays the annual or minimum tax to California and deducts that amount from its Arizona taxable income. If California’s recent losses at the administrative and judicial levels on this nexus issue are any indication, Arizona’s concerns may have some basis.
Arizona’s Motion to Challenge the Extent of California’s Tax Jurisdiction
On Feb. 28, 2019, Arizona moved for leave to file a complaint with the U.S. Supreme Court,1 challenging California’s policy of extraterritorial tax assessment and enforcement of its $800 annual tax for LLCs and $800 minimum franchise tax for corporations (collectively the “annual and minimum taxes”).2 Arizona alleges:
California is not content to assess the “doing business” tax solely against entities actually conducting business in California, however. Instead, California assesses the “doing business” tax so expansively that it reaches out-of-state companies that do not conduct any actual business in California, and indeed have no connection to the state except for purely passive investment in California companies (hereinafter, “[e]xtraterritorial [a]ssessments”). For example, as described below, California has made [e]xtraterritorial [a]ssessments against several Arizona-based companies that have no connection to California whatsoever except purely passive investment in an LLC doing business in California.3
Arizona claims these extraterritorial assessments by California violate the due process clause, commerce clause and the Fourth Amendment.
Arizona asserts the due process clause “minimum contacts” standard is not satisfied through passive investment in a corporation or LLC. Arizona also asserts that California’s extraterritorial assessments violate all four-prongs of the commerce clause requirements under Complete Auto.4 Furthermore, Arizona maintains that California’s seizure orders to out-of-state bank accounts violate the Fourth Amendment because California issues such orders without a warrant or any other judicial involvement and are unreasonable seizures.
If true, Arizona claims these constitutional violations cause injuries to both Arizona-based LLCs and Arizona. Based on extrapolation, Arizona claims Arizona-based LLCs who have passive investments in LLCs doing business in California pay about $10.6 million a year to California. Using the same extrapolation, Arizona claims it loses approximately $484,000 in annual revenue because payment of taxes to California is generally a deductible business expense under Arizona law. Perhaps anticipating that other states may suffer from a similar revenue loss due to the reach of California’s annual and minimum taxes, on April 10, 2019, Arizona filed a blanket consent to filing of amicus curiae briefs in support of or in opposition to Arizona’s motion.
The California Franchise Tax Board, or FTB, first learned of this matter on March 5, 2019, and is working with the California solicitor general and attorney general to oppose Arizona’s motion.5 California requested, and the Supreme Court granted, an extension to respond to Arizona’s motion by May 24, 2019.
Satview and Swart
In the Matter of the Appeal of Satview Broadband Ltd.,6 the California Office of Tax Appeals rejected the FTB’s broad interpretation and application of California’s “doing business” standard. Satview Corp. held a 25 percent passive, nonmanaging member interest in a limited liability company that did business in California. The corporation had no other connections to or activities in California. The OTA found the “doing business” status of an LLC is not automatically attributed to its nonmanaging minority owner where it had no power or authority, direct or indirectly, to participate in the LLC’s management or operations. The OTA stated:
Without any allegation — much less any showing — that [Satview] had any ability or authority, directly or indirectly, to influence or participate in the management or operation of [an LLC doing business in California], we cannot uphold FTB’s position that [the LLC’s] doing-business status may be attributable to (i.e., flow through to) [Satview]. Merely pointing to the fact that [Satview] held a nonmanaging minority interest in an LLC that was doing business in this state does not, standing alone, satisfy the requirement that FTB show a rational basis for its determination.
The OTA concluded that Satview was not doing business in California. Approximately a month after the OTA decided Satview, the FTB issued legal ruling 2018-01,7 disregarding the OTA’s “doing business” analysis and conclusions in Satview. In fact, even in decisions prior to Satview, the FTB also narrowly interpreted authorities that limit the reach of California’s “doing business” standard.
In Swart Enterprises Inc. v. Franchise Tax Bd.,8 the court found Swart Enterprises was not doing business in California based solely on its minority 0.2% interest in a California LLC. After Swart, the FTB responded with FTB notice 2017-01,9 stating it will only follow Swart in situations with the “same facts,” meaning any out-of-state companies that hold more than a 0.2% passive interest in a pass-through doing business in California would themselves be doing business in California and subject to California’s annual or minimum tax. And this is precisely the litigating position the FTB took in Satview a year later.
Similarly, in the Appeals of Amman & Schmid Finanz AG, et al.,10 the State Board of Equalization concluded limited partners were not doing business in California simply because of their interest as limited partners in a partnership that was doing business in California. After Amman & Schmid, the FTB issued legal ruling 2014-01,11 describing the decision as a “narrow exception” not applicable to LLCs.
These cases demonstrate that even those taxpayers who themselves have no direct activities in a jurisdiction may find themselves within the reach of the jurisdiction’s taxing authority. Consistent with past positions, states like California may continue to test the limits of their tax reach on out-of-state companies. Although these limits are constantly evolving due to case law and authorities, perhaps the U.S. Supreme Court will accept Arizona’s motion and provide some certainty and frame the bounds by which a state may assert nexus on out-of-state, passive owners of in-state pass-throughs.
- Motion for Leave to File Bill of Complaint, Bill of Complaint, and Brief in Support, Arizona v. California, No. 220150 (U.S. Mar. 4, 2019) (hereafter Arizona Motion).
- See Cal. Rev. & Tax Code §§ 17941(a), 23153(d)(1).
- Arizona Motion, Bill of Complaint, p. 2.
- Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977).
- FTB Litigation Update Materials, SALT Committee Meeting, Taxation Section of the California Lawyer’s Association, Mar. 27, 2019, at 5.
- In the Matter of the Appeal of Satview Broadband Ltd., OTA Case No. 18010756 (Sept. 25, 2018). This opinion is listed as nonprecedential.
- Legal Ruling 2018-01 (Oct. 19, 2018).
- Swart Enterprises Inc. v. Franchise Tax Bd. , 7 Cal.App.5th 497 (2017).
- FTB Notice 2017-01 (Feb. 28, 2017).
- Appeals of Amman & Schmid Finanz AG, et al., 96-SBE-008, April 11, 1996.
- Legal Ruling 2014-01 (July 22, 2014).