Nearly a half-century ago, during Jerry Brown’s first stint as governor, he and state legislators became embroiled in an extremely complex political squabble over taxing the incomes of multinational corporations.
At the time, California employed what was dubbed “unitary taxation,” requiring such corporations to report all income, including that of foreign subsidiaries, upon which a formula would calculate the portion subject to state taxation.
Big multinational businesses, particularly those based in Japan and Great Britain, loathed the system, saying it resulted in California claiming a disproportionate share of taxable income and, at least in some instances, double taxation.
The corporations wanted a “water’s edge” system in which only activities within the state would be taxed, and they simultaneously lobbied for California to change its system or the U.S. government to intercede.
Brown initially supported unitary taxation, taking his cue from Martin Huff, the state’s chief taxation official, who said it prevents corporations from avoiding California’s taxes with self-serving internal accounting maneuvers.
However, after getting an earful of criticism of unitary taxation during a visit to Japan, Brown did one of his characteristic 180-degree pirouettes, called for changing the system to encourage foreign investment, and accused Huff of giving him “flaky data.”
Huff, a crusty and outspoken veteran state official, accused Brown of lying, but the governor retaliated by making a deal with state legislators to repeal a law that gave Huff, the executive director of the Franchise Tax Board, extraordinary protection from political interference.
Huff had angered legislators by publicly calling for their per diem living expense payments to be treated as taxable income, and as soon as his shield was lifted, Huff resigned.
The underlying issue continued to smolder, but after the U.S. Supreme Court validated the legality of the unitary system in 1983 corporate interests renewed their drive for change. And in 1986 legislators and Brown’s successor, George Deukmejian, split-the-difference, giving corporations an option to use either a unitary or water’s edge method of calculating tax liability.
Ever since, corporations and state tax officials have jousted over use of the options in specific cases; one of which has emerged as a new test of how the state taxes corporate profits.
Microsoft used the water’s edge option in its 2017-18 state tax return, resulting in a squabble with tax collectors over how the company treated its dividends from foreign subsidiaries. Microsoft sought a $90.9 million refund. The Franchise Tax Board rejected its claim, but the company prevailed in an appeal to the Office of Tax Appeals, essentially a tax court.
Despite Microsoft’s victory, the Franchise Tax Board, warning that the decision could result in multi-billion-dollar refunds, sought support from Gov. Gavin Newsom and the Legislature.
Newsom and legislators responded with language in a budget trailer bill declaring that the Franchise Tax Board’s position is state law, regardless of Microsoft’s win on appeal. But after Newsom signed the bill, two lawsuits were filed to challenge its constitutional validity, contending that it would allow the state to reach back several decades to increase corporate taxes. The suits are still pending.
A new wrinkle in the decades-long wrangle over corporate taxation surfaced this month. The Climate Center and a coalition of environmental groups issued a report contending that big multinational oil companies, with help from then-President Ronald Reagan, pressured the Legislature into passing the 1986 legislation providing a water’s edge option.
The report says that water’s edge has saved companies billions of dollars in taxes and declares, “It’s time to begin to close the Pandora’s Box that California opened in creating water’s edge nearly four decades ago.”
Here we go again.