By: David J. Herzig
Earlier this year, the Washington Supreme Court held that the retroactive application of the legislature’s amendment to a Business & Occupation (B&O) tax exemption revising the definition of “direct seller’s representative” to conform to the Washington Department of Revenue’s interpretation of the exemption did not violate a taxpayer’s rights under due process, collateral estoppel, or separation of powers principle.
Like most states, Washington had a B&O tax for “the act or privilege of engaging in business activities.” Under the original law, out-of-state sellers were exempt if they acted through a representative. DOT Foods shows up in Washington and sells through a wholly owned subsidiary to avoid the B&O tax.
In 1999, the Washington Department of Revenue changed its interpretation of the statute to subject DOT and others to the B&O tax. Dot challenged that change (215 P.3d 185 (Wash. 2009) “DOT I”)) and won. DOT I applied for the tax periods 2000-2006.
DOT then sought a refund for the period Jan. 2005 – Aug. 2009 (not the time period of DOT I). In the meantime, in 2010 the Washington State Legislature changed Wash. Rev. Code Sec. 82.04.423(2) in response to the DOT I ruling. The statute both retroactively and prospectively changed the statute. Based on the statutory change, the Washington Department of Revenue rejected the refund claim.
For the period covered by DOT I, DOT and Washington agreed on a settlement for a 97% refund for B&O taxes paid. For the May 2006 to December 2007 period (after DOT I), the refund request was denied. DOT challenged the retroactive application under the theories of collateral estoppel, separation of powers, and due process. DOT lost in the Washington Supreme Court and now has appealed to the US Supreme Court.
The test for whether or not retroactive tax legislation satisfies Due Process is United States v. Carlton, 512 U.S. 26 (1994). Carlton applied a rational basis test. The Court stated retroactive tax legislation would not violate due process if, “legitimate legislative purpose furthered by rational means.” According to the ACTC brief, “The Washington Supreme Court ignored the unique circumstances of the Carlton case, which involved the correction of an obvious legislative error that was identified very soon after the statute was enacted and which the taxpayer was admittedly exploiting for its own benefit.”
The ACTC brief does a good job of summarizing the history of the Carlton case. But briefly, “[b]uried within the Act (§1172 of the Act, codified as 26 U.S.C. §2057) was a special provision that provided an estate tax deduction for sales of employer securities to an employee stock ownership plan (“ESOP”). As enacted, the deduction equaled 50% of the proceeds received by the estate from a qualified sale of employer securities to an ESOP. The provision did not require that the employer securities sold to the ESOP be owned by the decedent at the time of his or her death. This was an acknowledged clear oversight by Congress. The mistake may have resulted from a failure of the drafters to focus upon this aspect of the provision….
Taxes-The Tax Magazine, published on November 1, 1986, nine days after the Act was signed by President Reagan, observed that ‘[t]he availability of this deduction appears to be virtually unlimited. There is no restriction that it apply to stock that is not readily tradable on an established market,that the decedent have been an employee of the employer maintaining the ESOP, or that the decedent have owned the employer securities at the time of death.'”
“Within three months of the Act’s enactment, during January 1987, the Service announced that it would apply the provision as if it required that the decedent own the ESOP stock on the date of death ‘[p]ending the enactment of clarifying legislation.'”
“Congress amended the statute on December 22, 1987, effective as if it had been enacted fourteen months earlier when the Act became law. The likelihood that corrective retroactive legislation would be enacted was apparent to many from the date on which the Act became law, and the public at large was advised that such changes would occur within three months of the enactment of the law.”
Here we are looking at a 27-year retroactivity period! That seems much worse the the facts in Carlton. Moreover, in Carlton, it was harder for the taxpayer to argue any real reliance on the statute so why is this action not “irrational on its face?”
First, the Washington Supreme Court rejected the taxpayer’s argument that a 27-year retroactivity period was per se unconstitutional. The test is two fold, according to the Washington Supreme Court, Carlton only requires that the retroactive period must be “‘rationally related’ to a legitimate legislative purpose.”. “[T]he length of time that has elapsed since a statute’s original enactment is not dispositive.” Although, a 27 year look back certainly seems to cut against a rational basis. (Although there is a Washington Supreme Court case, W.R. Grace & Co. v. Department of Revenue,973 P.2d 1011 (Wash. 1999), that permitted a 37-year retroactivity period).
But, the Washington Supreme Court does not have to address the 27 year period, but only a 4 year period. And according to the Washington Supreme Court, this 4 year period “is well within the range of retroactivity periods that we have previously upheld.” It should be noted that this is not necessary a universally accepted position; some state courts have rejected retroactive tax positions as short as 16 months (James Square Assocs. LP v. Mullen, 993 N.E.2d 374 (N.Y. 2013)), and 2 years ( Rivers v. State, 490 S.E.2d 261 (S.C. 1997)). If the US Supreme Court hears the case and the Court believes that retroactive taxation is permissible, then guidance or a standard of the period of retroactivity would be welcome for taxpayers.
If the retroactive period alone is not enough to violate due process, then the Carlton test must be applied. Was there rational basis for the legislation? According to the Washington Supreme Court, this legislation was not merely to raise tax for taxing sake as ACTC remarks in its brief. Although, that was an important principal, the Washington Supreme Court also pointed to the legislative history of the revision smoothing the tax preferences between in and out of state business (“provided ‘preferential tax treatment for out-of-state businesses over their in-state competitors and now creates a strong incentive for in-state businesses to move their operations outside Washington.’”) The Washington Supreme Court relied on another earlier decision, In re Estate of Hambleton, 335 P.3d 398 (Wash. 2014), cert. denied, 136 S. Ct. 318 (2015), which found legitimate legislative purpose in restoring taxpayer parity.
Obviously, the taxpayers, ACTC and other amicus curiae feel differently and have appealed the state Supreme Court decision to the Supreme Court of the United States. Whether certiorari will be granted to not will be seen. Although, more clear guidance on retroactive legislation would be rather helpful given the expanding rate in which states are using this technique. No longer is the application merely clean-up of unforeseen mistakes, like the ESOP provisions.
Dan Hemel and I had an interesting email on this and I thought some of our exchange could prove interesting for a commentary on this case. Suppose for example, that instead of the statute in Dot Foods, the Washington legislature had enacted a statute along the following lines in April 2010:
(a) The B&O tax due for the second quarter of calendar year 2010 is equal to 0.5% times gross receipts from sales inside Washington state from May 1, 2006, to June 30, 2010.
(b) A credit is allowed against the tax imposed by subsection (a) for B&O taxes previously paid with respect to sales during the period to which subsection (a) applies.
The effect is the exact same as the statute in Dot Foods.
What’s wrong with this statute? It applies to a period (2006-2010) that’s already started, but surely there is no rule against applying a revised statute to a period that’s already begun (on January 21, 2017, the President and Congress can change the tax year 2017 rates). Now we can quibble that yes the period began, but also, these years are not closed. So, is there enough reliance by the taxpayer?
Remember this is not a protected class. The statute only has to be rationally related. Here that argument is easy: the state wants to make sure that businesses that have benefitted from the use of state infrastructure in the prior four years contribute to the cost of that infrastructure (“our bridges are crumbling and one reason is that some folks have been using them without paying”). Plus it raises revenue.
But, is this further than Carlton envisioned retroactive taxing legislation? Carlton was fixing a known error and not so much a retroactive application but a clear mistake. In my prior rate example, how much reliance did taxpayers have for 20 days in 2017? Would this work for revision in 2018?
Also, there is also a second normative question. Is this type of behavior by the states is good? For example, why would California not look at every major corporate income tax return for treatment of an issue? Then, figure out how to tinker with the California laws to gain revenue and cloak it in some rational reasoning? A corporation already took a reporting position and spent resources based on the behavior the code was encouraging or forewent doing something based on a behavior the code was discouraging. Now, the state is modifying the rules.
This is what happened in DOT. Washington encouraged DOT to operate as a direct seller through a wholly owned subsidiary. But, retroactively, direct selling companies now owe tax for organizing this way and could lose their exemption if they do the following acts which were permitted prior to the statute:
- Sell anything other than a “consumer product” (including sales kits, whether or not at cost, and possibly including consumer services);
- Allow a customer to order products directly from the company (via phone, mail, website, etc., whether or not the customer was enrolled by an in-state direct seller representative); or
- Have any product resold by a direct seller representative’s customer (or presumably anyone else) in a “permanent retail establishment.”
This shift is not merely transitory, but, rather effects the fundamental structure and operations of the company.
Personally, I am not as concerned with the open year argument as the reliance argument. I think that normatively it is problematic for states to retroactively tax because the behavior ex post was not as intended. And the hindsight period, at least according to the Washington Supreme Court, is basically forever.
It would be easy counter to this argument — the market will respond to state behavior by not doing business in that state. I generally agree with the counter. But, with certain states that are market powers, that theory does not work well. (Since this is not an ideal marketplace from an economic theory perspective, market power creates a distortion in favor of dominate firms). For example, market forces are a deterrent for Kentucky. But they are not in Texas, California, Florida, Illinois, or New York. The population density, the work skill sets, etc., give these states market power.
To end (if you are still with me THANKS!! and here is your cat video link as a reward), the question the Supreme Court would be dealing with is whether there is a judicially workable standard. Here, I think that Carlton imposes a judicially manageable standard and the Supreme Court should favor the state actor.
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