WASHINGTON - California's already bleak budget outlook took another blow Monday as the U.S. Supreme Court let stand an opinion striking down part of the state's corporate tax code.
The action eventually could cost the state upward of $1.5 billion, by some estimates. In the short run, the state likely will face demands for hundreds of millions of dollars in corporate tax refunds.

"Not the way you want to start your workweek," said H.D. Palmer, deputy director of the California Department of Finance. "It's going to be a substantial hit, there's no question about it."
Losing the case involving the deductibility of corporate dividends "will have a major negative revenue impact on the general fund budget," California Legislative Analyst Elizabeth Hill agreed.

In a recent report, Hill pegged the potential tax refunds at between $500 million and $1.5 billion. "The exact magnitude and timing of such refunds is not clear at this time," Hill noted, but "in addition, the state could face ongoing annual revenue reductions of $180 million under a worst-case scenario."

For many corporations, though, the Supreme Court's decision means an opportunity to recoup tax payments they've maintained violate the Constitution. The court's decision not to hear California's appeal tracks closely with other recent decisions eliminating certain state tax provisions as interfering with interstate commerce.

"I think it was, frankly, to be expected," said Thomas Steele, the San Francisco-based attorney who challenged California's state corporate tax provision. "We were very much expecting the court to deny (California's appeal), and I think most tax experts were as well."

The case known as Franchise Tax Board v. Farmer Bros. was one of dozens that the Supreme Court announced Monday it would not take up for full consideration. California needed to get the votes of at least four of the court's nine justices for the case to be considered.

Steele, a University of California, Davis, law school graduate who's now with the firm Morrison & Foerster, represents Farmer Bros.

Starting administratively, and working its way through the courts, the company challenged the dividends-received deduction in the state's tax code.

This provision permits corporations a deduction for dividends received from income that's already been taxed in California. In the case of Farmer Bros., for instance, the company received a Pacific Gas and Electric Co. dividend of $17,550 in 1992. Essentially all of this dividend was deductible, because PG&E already had been taxed for the income upon which the dividend was based.

On the other hand, Farmer Bros. also reported a dividend of $4,800 from Merrill Lynch, and very little of that was deductible.

The provision has been part of California's Revenue and Tax Code since 1929, with officials describing it as a way to avoid double taxation - at least, with regard to California-based income.

"I don't think they saw the unintended consequence of disadvantaging interstate commerce," Steele said.

The Constitution's all-important commerce clause gives Congress the power to regulate interstate commerce. By extension, through what's called the dormant commerce clause, this provision blocks states from erecting barriers against one another. In May 2002, the Los Angeles-based 2nd District Court of Appeal concluded that California's dividend provision amounted to just such an economic barrier.

"(It) is discriminatory on its face," the state appellate court ruled, because "the dividends-received deduction scheme favors dividend-paying corporations doing business in California over dividend-paying corporations which do not do business in California and pay no taxes in California."

In a somewhat similar 1996 case involving North Carolina, the Supreme Court unanimously struck down that state's provision that essentially levied higher taxes on income from out-of-state companies.