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River Garden Retirement Home v. Franchise Tax Board

July 15, 2010


(San Francisco City and County Super. Ct. No. CGC07-467783). Hon. Peter J. Busch.

The opinion of the court was delivered by: Reardon, J.


For years Revenue and Taxation Code*fn1 section 24402 allowed California corporate taxpayers to deduct a portion of the dividends they received from another corporation when those dividends were included in the payer's measure of California franchise, income or alternative minimum tax. The court in Farmer Bros. Co. v. Franchise Tax Board (2003) 108 Cal.App.4th 976, 980, 986-987 (Farmer Bros.) held that section 24402 violates the commerce clause of the United States Constitution by allowing the dividends received deduction where the dividend-paying corporation was subject to California tax, but disallowing it where such corporation was not subject to California tax.

Appellant River Garden Retirement Home (River Garden or the company) claimed the dividends received deduction for tax years 1999 and 2000, but, in the wake of Farmer Bros., respondent Franchise Tax Board (FTB) disallowed the deductions for tax years ending on or after December 1, 1999, and issued notices of proposed assessment for additional tax for the two years at issue in this case. As well, the FTB imposed an amnesty penalty under California's tax amnesty program*fn2 because River Garden did not pay the tax deficiencies announced in those notices until two years after the close of the amnesty period. Section 19777.5, subdivision (a)(2) subjects eligible taxpayers, such as River Garden, who did not participate in the amnesty program to a penalty on amnesty-eligible deficiency assessments that remain "due and payable" after the close of the amnesty period. After unsuccessfully pursuing administrative remedies, River Garden sued for the refund of California tax and tax penalties, losing below.

Contrary to River Garden's assertions on appeal, we conclude, among related points, that section 24402 cannot be saved by severance of the offending language or by reformation. Moreover, the FTB proceeded with proper authority to remedy the commerce clause violation infecting section 24402, and the remedy of disallowing the dividends received deductions for the years at issue did not defy the due process prohibition against excessively retroactive tax increases. As well, the FTB's decision to recoup the deductions for those years did not run afoul of article XIII A, section 3 of the California Constitution requiring a two-thirds vote of the Legislature to enact revenue increasing tax laws.

On the amnesty front, we hold that the deficiency assessments for tax years 1999 and 2000 were "due and payable" within the meaning of section 19777.5, thereby empowering the FTB to assess amnesty penalties for those years. Additionally, section 19777.5 does not operate retroactively, and therefore imposition of the amnesty penalty does not raise due process concerns. Finally, there is no statute of limitations bar to imposing the amnesty penalty for the 1999 tax year. Accordingly, we affirm the judgment in its entirety.


River Garden, a California corporation, operates a retirement home in Lodi. The company received dividends in 1999 and 2000 in the respective amounts of $46,271 and $55,025. River Garden deducted 80 percent of the dividends it received in those years on its California tax returns, pursuant to section 24402.

On audit, FTB disallowed 100 percent of the dividends received deduction which River Garden claimed for those years on grounds that Farmer Bros. declared section 24402 unconstitutional and invalid. Implementing that decision, the FTB announced that it would allow section 24402 deductions for tax years ending prior to December 1, 1999, but disallow them for tax years ending on or after December 1, 1999. In keeping with this policy, in April 2004 the FTB issued to River Garden notices of proposed assessment in the amount of $2,666.08 (1999) and $2,704.18 (2000). River Garden protested the notices, the FTB published notices of action affirming them, and thereafter in December 2004, River Garden appealed to the State Board of Equalization.

Meanwhile, California's tax amnesty program went into effect in February 2005 while River Garden's administrative appeal was pending. The amnesty program afforded taxpayers a two-month window (Feb. 1, 2005 through Mar. 31, 2005), to apply for amnesty and thereafter pay in full all outstanding tax liabilities and interest for tax years prior to January 1, 2003, thereby avoiding tax penalties, fees and possible criminal action. (§§ 19731-19733.) River Garden was aware of the tax amnesty program, but did not remit payment to the FTB during the two-month window of any portion of the tax deficiencies assessed against it for the years in question.

The State Board of Equalization affirmed the FTB's notices of action in September 2006. There followed a series of notices from the FTB to River Garden: (1) January 18, 2007 notice of balance due for tax, interest and penalty totaling $8,844.53; (2) March 23, 2007 corporation past due notice for tax, interest and penalty totaling $8,969.46; and (3) April 27, 2007 corporation formal demand for tax, interest and penalty in the amount of $9,038.51. On May 9, 2007, River Garden remitted the full amount, which included an amnesty penalty pursuant to section 19777.5 for failure to participate in the tax amnesty program and clear the unpaid tax and interest. Thereafter the company filed a claim for refund, the FTB denied the claim, and River Garden sued for a refund of the tax assessments as well as the amnesty penalties. The trial court sustained the FTB's demurrer to River Garden's challenge to the tax assessment, and subsequently granted summary judgment in the FTB's favor on the challenge to the amnesty penalty. This appeal followed.


A. Section 24402 Deduction

In its opening brief, River Garden argues that we should preserve section 24402 by severing the portion of the statute that unconstitutionally limits the dividend deduction to those dividends paid from California sources. After the brief was filed, the Court of Appeal in Abbott Laboratories v. Franchise Tax Bd. (2009) 175 Cal.App.4th 1346 (Abbott) persuasively rejected this proposition. River Garden contends in its reply brief that the Abbott court got it wrong. Now conceding that section 24402 has been "conclusively determined to be unconstitutional, and that question is no longer in issue," River Garden frames the question presented on appeal this way: "[W]hat is the proper remedy for River Garden for the years at issue?" Its attempt to recycle severance as the remedy for curing section 24402 of its unconstitutionality is not persuasive because the substance of the argument is the same. Nevertheless, River Garden is correct that the ultimate issue is articulating the proper remedy. Before reaching that issue, some background on the statute's constitutional infirmity and its insusceptibility to salvation by separability is in order.

1. Background

We start with Farmer Bros. There, the taxpayer filed state tax returns claiming a dividends received deduction for all dividends it received for the years at issue, regardless of whether the dividend-paying corporation paid California taxes or not. The taxpayer sought refunds totaling more than $800,000 plus interest, asserting that section 24402 contravened the "dormant" commerce clause*fn3 because on its face the statute discriminates against interstate commerce by improperly taxing income that is not attributable to business taking place in this state, and the deduction could not be justified as a lawful compensatory tax. The trial court agreed, declaring that section 24402 facially and unconstitutionally burdens interstate commerce. It awarded refunds of $811,000 plus interest and costs. On appeal the FTB challenged the substantive ruling that section 24402 is unconstitutional, but did not attack the remedy. (Farmer Bros., supra, 108 Cal.App.4th at pp. 983-985.)

Affirming, the Farmer Bros. court first pointed out that the dormant commerce clause "prohibits economic protectionism--that is, regulatory measures designed to benefit in-state economic interests by burdening out-of-state competitors." (Farmer Bros., supra, 108 Cal.App.4th at pp. 985-986.) Section 24402 favors dividend-paying companies that do business in California and pay California taxes over dividend-paying companies that do not do business in California and pay no taxes here. Thus, the deduction discriminates between transactions based on an interstate element, branding it facially discriminatory under the commerce clause. (Farmer Bros., supra, at pp. 986-987.) Specifically, the discriminatory impact of this scheme operates to favor domestic corporations over their foreign competitors in raising capital among California residents, and by the same token tends to discourage domestic corporations from plying their business in interstate commerce. (Id. at pp. 987-988; accord, Ceridian Corp. v. Franchise Tax Bd. (2000) 85 Cal.App.4th 875, 883-887 (Ceridian) [concluding that § 24401, which allows deduction for insurance subsidiary dividends only to corporations domiciled in California, and limits amount of deduction pursuant to formula based on subsidiary's gross receipts, payroll and property within state, was discriminatory on its face, in violation of commerce clause].)

Like the plaintiff in Abbott, River Garden initially proposed that we rewrite section 24402, subdivision (a) to sever its invalid segment. It now advocates severance as the remedy required by state law. Indeed, section 23057 does allow for severance, as follows: "If any... subsection, clause, sentence or phrase of this part which is reasonably separable from the remaining portions of this part, or the application thereof to any person, taxpayer or circumstance, is for any reason determined unconstitutional, such determination shall not affect the remainder of this part, nor, will the application of any such provision to other persons, taxpayers or circumstances, be affected thereby."

The Abbott plaintiff argued that the statute should be revised to delete everything after "year," so that section 24402, subdivision (a) would read: " '(a) A portion of the dividends received during the taxable year.' " (Abbott, supra, 175 Cal.App.4th at p. 1357.) With this revision, the statute would allow a deduction in computing taxable income for dividends declared from the income of any corporation, regardless of whether its income was subject to California tax or not. The court in Abbott explained why such a revision is not constitutionally feasible.

While a severability clause such as section 23057 normally calls for sustaining the valid portion of the law when the invalid portion is mechanically severable, severability in these circumstances is not conclusively dictated. "To be severable, ' "the invalid provision must be grammatically, functionally, and volitionally separable." ' " (Abbott, supra, 175 Cal.App.4th at p. 1357.) An offending clause is volitionally separable where the remainder of the statute (1) is complete in itself and would have been adopted by the legislative body had it foreseen the statute's partial invalidation, or (2) comprises a completely operative expression of legislative intent. (Id. at p. 1358.)

The legislative history of section 24402 reveals that the intent of the original 1929 enactment*fn4 was to permit a deduction for dividends received by a corporation from other corporations, to the extent the dividends were based on business done in California, the idea being to avoid taxing the same dollar of corporate income more than once. (Abbott, supra, 175 Cal.App.4th at p. 1358, referencing Nelson, California's New Tax Laws; Corporation and Bank Tax Explained (Apr. 1929) 7 The Tax Digest 129 [by State Senator H.C. Nelson]; see also Safeway Stores, Inc. v. Franchise Tax Board (1970) 3 Cal.3d 745, 749-450; Burton E. Green Inv. Co. v. McColgan (1943) 60 Cal.App.2d 224, 232-233.) Thus, as enacted, section 24402, subdivision (a) confined the dividends received deduction to those dividends declared from income subject to California tax. To excise the language imposing this limitation on the dividends received deduction would impart a purpose to the statute that is quite different from the one enacted by the Legislature. (Abbott, supra, 175 Cal.App.4th at p. 1359.)

Apart from the authority to sever under a severability clause, courts also have the power to reform a statute to preserve its constitutionality. We may rewrite a statute to cure constitutional invalidity when we can assert confidently that " '(i) it is possible to reform the statute in a manner that closely effectuates policy judgments clearly articulated by the enacting body, and (ii) the enacting body would have preferred the reformed construction to invalidation of the statute.' " (Ceridian, supra, 85 Cal.App.4th at p. 889.) By heeding these factors, courts can steer clear of judicial policymaking disguised as statutory reformation, and thereby avoid impinging on the legislative function in violation of the separation of powers principles. (Kopp v. Fair Pol. Practices Com. (1995) 11 Cal.4th 607, 661.)

Courts consistently have declined to engage in judicial reformation when the statute at issue is a tax statute that defies the commerce clause. (Ventas Finance I, LLC v. Franchise Tax Bd. (2008) 165 Cal.App.4th 1207, 1224-1225 and cases cited therein.) Here judicial reformation is improper because the proposed reform is inconsistent with the Legislature's intent. To reiterate, the purpose of section 24402, as gleaned from the predecessor statute and its legislative history, is to avoid double taxation at the corporate level of income which has been subjected to California taxation in the hands of the dividend-declaring company. The proposed rewrite would not closely effect this policy, as clearly articulated by the enacting body, because it would not restrict the dividends received deduction to dividends declared from income already subject to tax in this state. To the contrary, the rewrite would go against the legislative policy by allowing a deduction for dividends declared from income of any corporation, regardless of whether that corporation paid taxes in California. (Abbott, supra, 175 Cal.App.4th at p. 1361.) Further, we have no reason to believe with any confidence that the 1929 Legislature would have preferred a global deduction from whatever corporate source, and thus we will not encroach on the legislative function by making a tax policy disguised as statutory reformation. (Ibid.)

2. Remedy

a. McKesson Corp. v. Florida Alcohol & Tobacco Div. Constitutional tax refund cases implicate the competing interests of taxpayers who seek a refund of wrongfully exacted taxes, versus the government in its efforts to protect the public purse. In McKesson Corp. v. Florida Alcohol & Tobacco Div. (1990) 496 U.S. 18 (McKesson), the United States Supreme Court addressed the question of the remedy due a taxpayer who challenges the constitutionality of a state tax. There, a wholesale liquor distributor challenged Florida's liquor excise tax as contravening the commerce clause. The preferential tax gave special rate reductions for certain products commonly grown in Florida and used in alcoholic beverages produced there. The manufacturer paid the taxes, applied for a refund, and when that was denied, sought declaratory and injunctive relief and a refund of excess taxes paid.

The court framed the question as "whether prospective relief, by itself, exhausts the requirements of federal law." (McKesson, supra, 496 U.S. at p. 31.) The answer was a resounding "no." "If a State places a taxpayer under duress promptly to pay a tax when due and relegates him to a post-payment refund action in which he can challenge the tax's legality,*fn5 the Due Process Clause of the Fourteenth Amendment obligates the State to provide meaningful backward-looking relief to rectify any unconstitutional deprivation." (Ibid., fn. omitted.) This response stemmed from previous cases establishing the rule that because exaction of a tax amounts to a deprivation of property, "the State must provide procedural safeguards against unlawful exactions in order to satisfy the commands of the Due Process Clause." (Id. at p. 36, fn. omitted.)

What, then, is "meaningful backward-looking" relief? When, as was the case in Florida, the state requires taxpayers to object to the tax in a post-deprivation refund suit, the state must give taxpayers both a "fair opportunity to challenge the accuracy and legal validity of their tax obligation" (McKesson, supra, 496 U.S. at p. 39, fn. omitted), as well as a " 'clear and certain remedy' " for the erroneous or unlawful tax collection (ibid.). Moreover, this duty to provide a " 'clear and certain remedy' " requires a state to make sure that the tax as ultimately actually imposed on the complaining taxpayer and its competitors during the contested tax period does not deprive the taxpayer of tax money in a way that discriminates against interstate commerce. (Id. at p. 43.) Refunding the difference between the tax McKesson paid and the tax it would have paid had it enjoyed favored rate reductions of course would constitute meaningful retrospective relief. Alternatively, consistent with constitutional limitations on retroactive assessments, Florida might assess and collect back taxes from McKesson's competitors who profited from the rate reductions during the periods in question. This approach would, in hindsight, erase the discriminatory effects of the tax scheme. (Id. at p. 40.) And finally, the state could devise a hybrid solution, partially refunding to taxpayers in the petitioner's shoes, and levying a partial retroactive tax on the favored competitors, "so long as the resultant tax actually assessed during the contested tax period reflects a scheme that does not discriminate against interstate commerce...." (Id. at pp. 40-41.)

The Supreme Court made it clear that when the tax scheme is pronounced unconstitutional because it discriminates against interstate commerce, the taxing entity "retains flexibility in responding to this determination" and may reformulate and enforce the tax during the contested tax period "in any way that treats [the taxpayer] and its competitors in a manner consistent with the dictates of the Commerce Clause. Having done so, the [taxing entity] may retain the tax appropriately levied upon [the taxpayer] pursuant to this reformulated scheme because this retention would deprive [the taxpayer] of its property pursuant to a tax scheme that is valid under the Commerce Clause." (McKesson, supra, 496 U.S. at pp. 39-40, italics omitted.)

Remanding the cause to the Florida Supreme Court for further proceedings, the court underscored that the state was free to fashion an appropriate remedy consistent with the minimum due process requirements articulated in its decision. (McKesson, supra, 496 U.S. at pp. 51-52.)

b. FTB Action

When, as here, a court declares a statute unconstitutional and that statute cannot be reformed, the statute is void in the sense that it is inoperative and unenforceable. (Kopp v. Fair Pol. Practices Com., supra, 11 Cal.4th at pp. 623-624.) In the wake of the Farmer Bros. decision declaring section 24402 unconstitutional, the FTB took the position that the statute was invalid and unenforceable for all years. Crafting a suitable remedy, it announced that all dividends received from noninsurance corporations would be deductible subject to the ownership limits of section 24402, subdivision (b) for tax years ending before December 1, 1999. On the other hand, the deduction would be disallowed for all tax years ending on or after that date. This solution removed the discriminatory tax treatment and restored equality to the taxing scheme by retroactively recouping ...

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