(This article originally was published by Law360 on January 16, 2020.)
The saga continues in Arizona v. California, Arizona’s U.S. Supreme Court challenge of California’s tax reach, but signs are strong it may be ending soon.
Last year, Arizona filed a motion to the court seeking to file a complaint against California under the court’s original and exclusive jurisdiction over controversies between states.1 Arizona contends California assesses and enforces its doing business tax (i.e., an $800 annual and minimum tax imposed on businesses doing business in the state) so expansively that it unconstitutionally “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.”2
After initial briefs were submitted from both California and Arizona, the court invited the U.S. solicitor general to express the views of the United States on the matter.3
The U.S. solicitor general filed an amicus curiae brief strongly urging the court to deny Arizona’s motion because the dispute does not warrant the court’s exercise of original jurisdiction, which it says should be exercised only sparingly.4 In response, Arizona filed a supplemental brief contending that the U.S. solicitor general’s brief “flounders for substantially the same reasons as California’s: extensive reliance on supposed factual complexity that does not actually exist.”5
This article first addresses the highlights of both the U.S. solicitor general’s brief and Arizona’s supplemental brief, and then concludes by providing some related practical insights.
U.S. Solicitor General’s Brief
The U.S. solicitor general’s amicus curiae brief roundly urges the court, based on the view of the United States, to deny Arizona’s motion.6
The U.S. solicitor general’s primary arguments consist of the following: (1) This dispute is not an appropriate case for the exercise of the court’s original jurisdiction; (2) Arizona’s concerns would be better suited to be raised and litigated in California by the Arizona entities subject to the tax; and (3) Arizona’s claims require more factual development.7
In arguing Arizona’s dispute does not warrant the court’s exercise of original jurisdiction, the U.S. solicitor general cites to colorful language from previous case opinions establishing the principle that “original jurisdiction should be invoked only ‘sparingly.’”8 Specifically, the U.S. solicitor general highlights the following points:
- “Original jurisdiction ‘is of so delicate and grave a character that it was not contemplated that it would be exercised save when the necessity was absolute’”;
- “The Court therefore has expressed ‘reluctance to exercise original jurisdiction in any but the most serious of circumstances’”; and
- “This Court will not exert its extraordinary power to control the conduct of one State at the suit of another, unless the threatened invasion of rights is of serious magnitude and established by clear and convincing evidence.”9
The U.S. solicitor general proceeds to acknowledge the court has explained “the model case for invocation of this Court’s original jurisdiction is a dispute between States of such seriousness that it would amount to casus belli [i.e., an act justifying war] if the States were fully sovereign.”10
After then listing the types of disputes that actually meet this high standard (e.g., controversies regarding property or boundaries, cases sounding in contract, enforcement of interstate compacts), the U.S. solicitor general swiftly concludes Arizona’s complaint does not make the grade.11
The U.S. solicitor general then proceeds to argue Arizona entities can and should litigate the alleged issues that Arizona is raising on their behalf regarding California’s purported extraterritorial tax assessment and enforcement. Specifically, that if Arizona entities are being harmed in the manner alleged by Arizona’s motion, they should challenge California’s doing business tax based on their investments in California limited liability companies through the California administrative procedures and court proceedings. When making this point, the U.S. solicitor general references two class action challenges on this issue.13
Additionally, the U.S. solicitor general argues Arizona’s claims need factual development on the affected Arizona entities subject to California’s tax and would benefit from authoritative interpretations of the relevant statutes by California courts.14
The brief notes two opinions in this area, Swart Enterprises Inc. v. Franchise Tax Board and In the Matter of the Appeal of Jali LLC,15 and argues that to the extent Arizona’s complaint is not covered by these decisions, the California Office of Tax Appeals and the California courts are best situated to determine, based on developed factual records, whether the doing business tax applies.16
Arizona’s Supplemental Brief
In Arizona’s supplemental brief, Arizona argues the arguments set forth in both the U.S. solicitor general’s brief and California’s previously filed brief fail for the same reasons.17
In a section of its supplemental brief titled “Seriousness and Dignity of Arizona’s Claims,” Arizona responds to the U.S. solicitor general’s arguments that this dispute does not warrant the court’s exercise of original jurisdiction.18
Arizona takes an interesting approach on the casus belli standard highlighted by the U.S. solicitor general, first noting that “the SG Brief notably refuses to offer any analysis under” the standard, and then argues somewhat confusingly “that standard makes this action a ‘model case’ for accepting jurisdiction.”19
Arizona also implies the U.S. solicitor general is being hypocritical by making this argument, because “the federal government would never tolerate equivalent conduct by other nations.”20
Arizona also argues that Arizona entities should not be required to challenge California’s doing business tax in California courts.21 According to Arizona, this position “merely perpetuate[s] the constitutional violations [because California] should not be able to seize [Arizona entities’] money and hold it as ransom to compel them to ‘voluntarily’ appear in California courts.”22
In addition, Arizona argues that within the last decade California courts have failed to produce a single precedential decision addressing Arizona’s claims, and there is no reason to be more optimistic about the next decade.23
In what could be characterized as an odd strategic choice, Arizona focuses its arguments predominantly on challenges to the completeness of its facts, or as Arizona phrases the issue: “nonexistent factual complexity.”24 Arizona asserts California’s official legal interpretations in Legal Ruling 2014-01, Legal Ruling 2018-01, Notice 2017-01, and Limited Liability Company Tax Booklet (2008) “have dispelled any doubt as to whether California is engaged in taxation based on purely passive investment.”25
Furthermore, Arizona asserts it has provided specific examples and documentary evidence where California imposed assessments based solely on passive investments in manager-managed LLCs.26 However, Arizona somewhat takes the wind out of its own sails on this point by concluding its brief with a request for a more limited grant if the U.S. solicitor general is correct that the case presents factual complexity and requires more factual development.27
If the court does not grant Arizona’s motion, there is no certainty regarding if and when a California court will produce a precedential decision to conclusively address Arizona’s claims.
This issue originally stems from a 1996 California State Board of Equalization decision in Appeal of Amman & Schmid Finanz AG,27 which held that corporate limited partners were not doing business in California simply because they had interests as limited partners in limited partnerships that engaged in business in California. Since then, the following decisions, rulings, and other notices were issued but uncertainty still abounds:
- FTB Technical Advice Memorandum No. 200658 (citing Amman & Schmid and holding that while an out-of-state LLC member receiving California-sourced income was subject to state income tax, it was not doing business for California franchise tax purposes).29
- FTB Legal Ruling 2014-01 (reversing course, the FTB describes Amman & Schmid as a narrow exception not applicable to LLCs).30
- Swart Enterprises Inc. v. Franchise Tax Board (California Court of Appeal opinion against the FTB finding that taxpayer’s passive holding of a 0.2% membership interest, with no right of control over the business affairs of the LLC, was insufficient to meet California’s doing business standard).31
- FTB Notice 2017-01 (informing taxpayers and their representatives that the FTB will follow Swart only in situations with the same facts—i.e., 0.2 % membership interest).32
- Appeal of Satview Broadband Ltd. (nonprecedential California Office of Tax Appeals ruling holding that merely holding a nonmanaging minority interest is not enough to qualify as doing business in California).33
- FTB Legal Ruling 2018-01 (immediately following but disregarding the nonprecedential Satview ruling, modifies FTB Legal Ruling 2014-01 to reconfirm FTB’s characterization of Swart as a “narrow exception” applicable only in limited circumstances, and noting in a hypothetical that a 15% membership interest, or 10% less than the fact pattern in Satview, “greatly exceeds” the 0.2% membership interest in Swart).34
- Appeal of Jali LLC (precedential California Office of Tax Appeals ruling holding that taxpayer was not doing business and subject to tax in California simply because its membership interest in a California LLC ranged between 1.12% to 4.75%, and that the 0.2% membership interest in Swart is not a “new, post-Swart bright-line ownership threshold” rule FTB maintains it is).35
Jali is particularly noteworthy. Although Jali is a precedential ruling issued in mid-2019 by the California Office of Tax Appeals, the FTB has not issued a statement on this decision. In fact, based on FTB’s issued guidance on this topic and the content of its website, a taxpayer would be hard-pressed to assume the FTB is not still taking the position it advanced before and in Jali.
For instance, Notice 2017-01, which states the FTB will follow Swart only in situations with the same facts (i.e., 0.2% membership interest), has not been amended or withdrawn from the FTB’s website.36
Legal Ruling 2018-01 has not been modified either, and still references the 0.2% membership interest as the benchmark standard: “Please note that Member J’s 15% membership interest in LLC I greatly exceeds the taxpayer’s 0.2% membership interest in the Swart Court of Appeal decision.”
Thus, even with a precedential decision at the California Office of Tax Appeals, California’s doing business tax is still murky territory.
Despite the history and confusion surrounding the California doing business tax, the U.S. solicitor general’s brief is a critical blow to Arizona’s chances of having its case heard before the court. The court typically defers to the U.S. solicitor general’s recommendations.
Since early 2017, the court has followed the U.S. solicitor general’s recommendations approximately 89% of the time.37 This similarly holds true for petitions involving tax related issues.38 Given the U.S. solicitor general’s position in Arizona v. California, the court may deny Arizona’s motion next month after the court’s upcoming January 24 conference on the matter.39
Even if the U.S. Supreme Court denies Arizona’s motion, Arizona may have succeeded in highlighting the burdens of the California doing business tax. California is proposing a first-year exemption from the $800 minimum tax paid by limited liability companies, limited partnerships and limited liability partnerships, which will provide around $100 million in tax relief per year.40 The California Legislature previously passed S.B. No. 349, which would have changed the minimum tax from $800 to a range of $200 through $800 depending on the amount of gross receipts, but California Gov. Gavin Newsom vetoed the bill.
1 For more details on this background, see our previous article: Calif. Business Tax May Provide Next High Court Nexus Test, Law360 (Apr. 16, 2019).
2 Bill of Complaint at 2, Arizona v. California, No. 22O150 (U.S. Mar. 4, 2019).
3 U.S. Supreme Court Docket, https://www.supremecourt.gov/search.aspx?filename=/docket/docketfiles/html/public/22o150.html (last visited Jan. 13, 2020).
4 Brief for the United States as Amicus Curiae at 6, Arizona v. California , No. 22O150 (U.S. Dec. 9, 2019).
5 Arizona’s Supplemental Brief in Response to CVSG Brief at 1, Arizona v. California, No. 22O150 (U.S. Dec. 19, 2019).
6 Brief for the United States as Amicus Curiae at 1, 6, Arizona v. California, No. 22O150 (U.S. Dec. 9, 2019).
7 Id. at 6.
8 Id. at 7.
10 Id. at 8.
11 Id. at 9.
12 Id. at 15.
13 Id. citing to The Rasmussen Co. v. California Franchise Tax Bd., No. CGC-16-554150 (Cal. Super. Ct. filed Sept. 8, 2016); Wein Realty LLC v. California Franchise Tax Bd., No. CGC-19-576007 (Cal. Super. Ct. filed May 14, 2019).
14 Id. at 18.
15 Swart Enterprises Inc. v. Franchise Tax Board, 7 Cal. App. 5th 497 (2017) and In the Matter of the Appeal of Jali LLC, OTA Case No. 18073414 (July 8, 2019).
16 Id. at 19.
17 Arizona’s Supplemental Brief in Response to CVSG Brief at 1, Arizona v. California, No. 22O150 (U.S. Dec. 19, 2019).
18 Id. at 7.
21 Id. at 9-10.
24 Id. at 1.
25 Id. at 2.
26 Id. at 4.
27 Id. at 12-13.
28 Appeal of Amman & Schmid Finanz AG, 96-SBE-008 (1996).
29 FTB Technical Advice Memorandum No. 200658 (Dec. 22, 2000).
30 FTB Legal Ruling 2014-01 (July 22, 2014).
31 Swart Enterprises Inc. v. Franchise Tax Board, 7 Cal. App. 5th 497 (2017).
32 FTB Notice 2017-01 (Feb. 28, 2017).
33 Appeal of Satview Broadband Ltd., OTA Case No. 18010756 (Sept. 25, 2018).
34 FTB Legal Ruling 2018-01 (Oct. 19, 2018).
35 Appeal of Jali LLC, OTA Case No. 18073414 (July 8, 2019).
37 Kimberly Strawbridge Robinson, “Trump Solicitor General Has High Court’s Ear as Ideologies Meet,” Bloomberg Law (June 12, 2019).
38 Compare CSX Transportation Inc., v. Alabama Department of Revenue, et al., No. 18-612, (June 24, 2019) (the U.S. Supreme Court followed the U.S. solicitor general’s recommendation to deny the petition), and Washington State Department of Licensing, v. Cougar Den Inc., No. 16-1498 (Apr. 22, 2019) (the U.S. Supreme Court followed the U.S. solicitor general’s recommendation to grant the petition).
39 U.S. Supreme Court Docket, https://www.supremecourt.gov/search.aspx?filename=/docket/docketfiles/html/public/22o150.html (last visited Jan. 13, 2020).
40 Gavin Newsom, Governor’s Budget Summary, Jan. 10, 2020, at 52.