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April 30, 2014
News Analysis: Oklahoma Supreme Court Protects Coffers, Mangles Commerce Clause
by Jennifer Carr

Full Text Published by Tax Analysts®

A recent Oklahoma Supreme Court decision addressing a statutory capital gains deduction for taxpayers whose headquarters are in the state contains questionable applications of commerce clause jurisprudence and misses the mark by failing to find the statute unconstitutional (CDR Systems Corp. v. Oklahoma Tax Commission, No. 109886 (Okla. 2014), rev'g No. 109,886 (Okla. Ct. Civ. App. 2013).

The 5-4 decision in CDR Systems, issued April 22, overturned a court of civil appeals substitute opinion from last year holding that 68 O.S. Supp. section 2358(D) is facially unconstitutional.

The statute grants a deduction for capital gains from the sale of real property or ownership in a company in three circumstances. The first, for non-Oklahoma companies, requires that the sold property be located in the state and have been held for five years. The other two deductions are for Oklahoma companies and are granted for proceeds from sales of property located in the state or from selling an ownership interest in a company. Oklahoma companies must have owned the property or the company itself for three years to receive the deduction. The statute defines an Oklahoma company as one whose primary headquarters have been in the state for at least three continuous years before the sale.

Court Opinions
CDR was a California corporation headquartered in Florida and registered to do business in Florida, Oklahoma, and three other states. In 2008 it entered into a stock purchase agreement to sell all its assets to Hubbell Lenoir City Inc. CDR, which had had a single shareholder since 1996, claimed the deduction for its stock sale on its 2008 Oklahoma tax return. The Oklahoma Tax Commission (OTC) denied the deduction because CDR had not been headquartered in Oklahoma for three prior years. An administrative law judge upheld that decision, which CDR appealed to the Oklahoma Court of Civil Appeals.

The appeals court rejected CDR's claims that the statute violated privileges and immunities and equal protection clauses but held that it was facially discriminatory in violation of the commerce clause because it taxes companies differently based on whether they are Oklahoma or non-Oklahoma companies.

Because the different treatment was discriminatory, the court concluded that the statute could be upheld only if the state could show a legitimate local purpose that could not be adequately resolved using nondiscriminatory alternatives. The court rejected the state's arguments that the statute's purpose was the legitimate goal of increasing investment in Oklahoma and that it was available to residents and nonresidents alike and thus was not discriminatory.

The court found that the distinction between Oklahoma and non-Oklahoma companies, which requires a company not headquartered in Oklahoma to have a longer-term investment in the state regardless of the nature of its overall investment, lacked a legitimate purpose sufficient to overcome the provision's facial discrimination. It also held that the statute need not be struck down in its entirety, saying it could be saved by removing the discriminatory distinction.

The state appealed, and the Oklahoma Supreme Court reversed, saying the dormant commerce clause did not apply. Quoting the U.S. Supreme Court's opinion in General Motors Corp. v. Tracy, 519 U.S. 278 (1997), the court found that the dormant commerce clause did not apply unless there was "actual or prospective competition between the supposedly favored and disfavored entities in a single market." Because CDR did not present evidence that a similar entity produced the same product and was headquartered in Oklahoma, the court found it could not show a commerce clause violation. It further concluded that the deduction was designed to invite investment in the state, not to penalize outsiders.

The court also rejected CDR's reliance on Fulton Corp. v. Faulkner, 516 U.S. 325 (1996), in which the U.S. Supreme Court struck down a North Carolina law that taxed proceeds from investing in companies that had North Carolina tax liability more favorably than proceeds from companies with no tax liability in the state. The Oklahoma court found that unlike in Fulton, in which the taxing scheme hurt interstate commerce, the Oklahoma statute granted a benefit for investing in the Oklahoma economy. According to the court, CDR could not show discrimination because it could not argue that the amount of business it did was affected by whether it received the deduction.

The court also found that the deduction did not have a discriminatory purpose or a discriminatory effect on interstate commerce. It pointed out that CDR had not argued that the deduction precluded it from making tax-neutral decisions regarding the sale of its assets. The court discussed Pike v. Bruce Church Inc., 397 U.S. 137 (1970), in which the U.S. Supreme Court said an Arizona statute requiring cantaloupes grown in Arizona to be packed there unconstitutionally burdened interstate commerce. The Court balanced the state's interest in fruit packing and origin identification against the expense of requiring the company to build an Arizona packing facility.

The Oklahoma court concluded that under Pike, the Oklahoma statute could be upheld because there was no evidence that "CDR considered relocating so as to receive this deduction" and thus its situation "simply does not rise to the level of coercive relocation demonstrated in Pike." As a result, CDR "failed to carry the heavy burden of proving this particular deduction unconstitutionally discriminates against interstate commerce."

Questionable Opinion

Three aspects of the opinion stand out, and not necessarily in a good way: reliance on Tracy, rejection of Fulton, and strange logical conclusions.

In Tracy, the issue was whether Ohio's taxation of sales by natural gas marketers and its exemption for sales by local distribution companies violated the commerce clause. The case stemmed from federal deregulation of the natural gas industry, which resulted in companies being able to sell gas other than through regulated local utilities. Ohio taxed the direct sales to customers, typically large industrial users, while exempting sales by local distribution companies, which provided the utility delivery mechanism and were subject to other regulations.

The Supreme Court's decision turned on whether the two sellers were similar enough that the disparate treatment violated the commerce clause. The Court concluded they were not because the local distribution companies' "bundled product reflects the demand of a market neither susceptible to competition by the interstate sellers nor likely to be served except by the regulated natural monopolies that have historically supplied its needs." That determination, combined with the state's interest in protecting captive utility customers, led the Court to conclude that Ohio's different tax treatment of the two entities was not discriminatory.

Inexplicably, the Oklahoma Supreme Court relied on Tracy to find that the commerce clause does not apply because CDR could not identify a company that also makes utility company fiberglass handholds and has its primary headquarters in Oklahoma. Nothing about Tracy requires that finding. The U.S. Supreme Court decided there was not unconstitutional discrimination because the groups being compared had different purposes and business models. Further, the tax at issue in Tracy was a sales tax, which frequently requires determining whether the same things are being sold by the same types of sellers.

Todd Lard of Sutherland Asbill & Brennan LLP said that "from the outset, it was very confusing as to why [the Oklahoma Supreme Court] thought the commerce clause didn't apply." Lard, who expressed surprise at the outcome given what he believed was a strong taxpayer argument, described the court's reliance on Tracy as "odd."

The court's requirement that CDR present an Oklahoma company for comparison is also troubling. That comparison isn't necessary because a comparison is built right into the statute -- companies with Oklahoma headquarters versus companies headquartered outside the state. And when discussing Tracy, the court quoted a law review article that said CDR Systems "is 'quite different from more familiar targets of Commerce Clause attacks, which . . . extract tax revenues disproportionately from out-of-state businesses.'" But that quote doesn't support the court's holding. It's actually a fairly apt description of the deduction statute -- CDR paid more taxes because it is headquartered out of state than it would have had it been headquartered in Oklahoma.

Perhaps even more problematic is the court's rejection of Fulton, in which the taxpayer owned stock in a company that did no business in North Carolina and therefore was subject to an intangibles tax on 100 percent of the stock's value. Had the taxpayer had North Carolina activity and paid taxes to the state, its intangibles tax burden would have been reduced proportionally based on North Carolina business activity. The U.S. Supreme Court struck down that regime because North Carolina business activity received more favorable tax treatment than business activity outside the state.

That leads to the third questionable aspect of the opinion: the court's strange logic and conclusions. Timothy Larason of Andrews Davis described the court's attempt to distinguish Fulton as "questionable." The case can be distinguished on factual grounds, but its gist is that states may not tax out-of-state activity less favorably than in-state activity.

The Oklahoma court distinguished Fulton because North Carolina "actively discouraged participation in interstate commerce by tying tax liability directly to the proportion of in-state versus out-of-state economic activity," but the Oklahoma statute does the same thing. The Oklahoma statute may not include any precise calculations, but relocating one's primary headquarters to Oklahoma results in more Oklahoma economic activity. The Oklahoma court's own description of Fulton appears to undermine its rejection of the case. And it shows that the kind of identical competitor the court wanted to see under Tracy is unnecessary for finding a tax statute unconstitutionally discriminatory.

Thomas Ferguson Jr. of Walker, Ferguson & Ferguson, who represented CDR, said he was disappointed with the decision, particularly regarding Fulton. He said he believed Fulton was controlling and that the court "missed the mark" in CDR Systems.

In discussing Fulton, the court wrote that the Oklahoma deduction "does not calculate tax liability based on the proportion of in-state activity to out-of-state activity. Rather, taxpayers subject to Oklahoma income tax receive the deduction for investing in Oklahoma's economy." That appears contradictory, but the court fails to explain how investing in Oklahoma's economy does not increase in-state activity.

Citing Westinghouse Elec. Corp. v. Tully, 466 U.S. 388 (1984), the court also wrote that the statute is not unconstitutional because "a company does not disqualify for the deduction because it increases its activities in another state." Yet that is exactly what happened in this case -- CDR had an increased Oklahoma tax burden because it chose to maintain its primary headquarters elsewhere.

In a final bit of dubious reasoning, the court agreed with the OTC that the deduction statute should be upheld because the "Legislature could have imposed a more burdensome means of promoting significant business investment in Oklahoma's economy." That argument is illogical because it presupposes that the statute is constitutional. One cannot justify an unconstitutional statute on the basis that it could have been more unconstitutional.

The close decision produced a strong dissent. Justice Douglas Combs used the correct analysis, writing that the regime "amounts to an out-of-state primary headquarters tax." As a result, it forecloses tax-neutral decision-making and creates an advantage for Oklahoma companies at the expense of those that operate elsewhere, he said, adding that the scheme "is similar to the one found to be facially discriminatory in Fulton."

No Good Way Out?

The court's opinion is problematic, but it should be noted that the court had to address unusual scenarios in the case itself.

First, Lard pointed out that even though favoritism has been rampant in state tax systems since at least Moorman Manufacturing Co. v. Bair, 437 U.S. 267 (1978), "it's unusual for a state to incentivize in-state activity by adjusting the tax base." Thus, the court was addressing an atypical situation, which may have presented some jurisprudential difficulties.

Second, if the court had struck down the law, creating a remedy would have been difficult. OTC spokeswoman Paula Ross reportedly said the state would have been liable for up to $400 million in refunds if the appeals court decision had been upheld and all eligible taxpayers had filed amended returns. Ross did not return requests for comment by press time.

Larason said that before the ruling, he suspected the court would find a way to protect the treasury but that he was still surprised by how it did that. He pointed out that the court could have canceled the deduction for all capital gains, but that that would have been unpalatable for state taxpayers who had relied on the provision.

Lard described the case as a "pretty good" subject for appeal, but according to Ferguson, CDR is still considering its options, including whether to file a motion for rehearing before the Oklahoma Supreme Court or a petition for certiorari with the U.S. Supreme Court.

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