In Legal Terms - March/April 1999

Supreme Court Strikes Down Alabama's Franchise Tax
Aside from the Senate situation (which is hopefully resolved as of the date this article is written), the biggest news story in Alabama of late was the release of the U.S. Supreme Court's decision in South Central Bell Telephone Co. v. Alabama, in which the franchise tax levied in Alabama on foreign corporations was struck down as unconstitutional. Everyone anticipated that this would be the final outcome, but the decision came quickly and it was still a stinging blow. The loss in future state revenue which will result from this decision is unknown at this time. However, in 1998, the State received about $119,000,000 in franchise tax, and 92% of that was from taxes paid by foreign corporations to Alabama.1 In other words, the state is looking at losing about $109.8 million dollars a year in tax revenues based on 1998 figures.

Until now, Alabama has treated foreign and domestic corporations differently for franchise tax purposes. A domestic corporation is taxed according to the par value of its capital stock, which as noted by the Supreme Court, the corporation may set at whatever level it chooses. See, Code of Alabama 1975, § 40-14-40. On the other hand, under Code of Alabama 1975, § 40-14-41, a foreign corporation is taxed according to the actual amount of its capital employed in this state. Challenging the validity of this law, South Central Bell and others sued the State claiming that the disparate treatment of foreign corporations in the state's franchise tax scheme violated the Commerce and Equal Protection Clause of the U.S. Constitution. The trial court ruled in favor of the State on procedural grounds and the Alabama Supreme Court upheld that decision without opinion. However, the plaintiffs appealed to the U.S. Supreme Court, which heard arguments in the case on January 19, 1999. The decision reversing the state court decision was rendered just two months later, on March 23, 1999.

In this case, the State had argued that the discrimination in the two taxes was justified on the ground that the tax on foreign corporations was a complementary or compensatory tax that offset the burden that a different tax (the domestic shares tax) imposes upon domestic corporations. The Supreme Court held in its opinion that a discriminatory tax cannot be upheld as "compensatory" unless the State proves that the special burden imposed on foreign corporations by the franchise tax is roughly approximate to the special burden on domestic corporations and that the taxes are similar enough in substance to serve as mutually exclusive proxies for one another. Citing the plaintiffs' assertion that the foreign franchise tax burden far exceeded the domestic franchise tax and the domestic shares tax combined, the Supreme Court rejected Alabama's attempted justification for the discrimination, finding that the relevant tax burdens were not "roughly approximate" and were not similar in substance. The Court held, as expected, that the tax "facially discriminates against interstate commerce", and that, because the State could not offer a sufficient justification for that discrimination, the tax was unconstitutional on Commerce Clause grounds.

The impact of this decision is, as yet, unknown. It appears that the Supreme Court only struck down the foreign franchise tax, and thus the tax on domestic corporations remains in effect. However, this will generate somewhere around $10,000,000 a year, instead of $119,000,000. Moreover, the issue of whether the state will have to refund any taxes already collected remains undecided. The U.S. Supreme Court remanded the case to the Alabama Supreme Court to decide that and any other remaining issues. The Department of Revenue will argue strenuously that this decision should have prospective effect only – let's hope they are successful. Of course, in addition to waiting for all issues in the case to be decided, the State is also faced with finding some way to make up this loss of revenue. It is unknown how this issue will be resolved, particularly given that we are still in a "no new taxes" mode in Alabama. I would wager that legislation on this issue will be forthcoming soon after the Legislature returns to work. We will need to watch carefully to see how that issue is addressed.

Any substantial loss in state revenue naturally has an impact on county government, since much of counties' funding comes from the state, and the risk is always there that county revenues will be cut. However, the demise of the foreign franchise tax also has a significant direct impact on the counties in this state. 6.65% of the proceeds from the franchise tax is apportioned to “the several counties in which the corporation does business, in proportion to the amount of taxable property of such corporation in each of said counties.” Code of Alabama 1975, § 40-14-43. Approximately $7.91 million dollars in franchise tax proceeds were distributed to counties in 1998. Unfortunately, if you deduct the percentage received from foreign corporations (which is the portion now declared invalid), that figure is reduced to a mere $632,800!

It is hard to argue with the U.S. Supreme Court in its ruling in this case. Justice Breyer writing for the majority noted that the average domestic corporation pays only one-fifth the franchise tax it would pay if it were treated as a foreign corporation. This certainly supports the argument that foreign corporations have received disparate and unequal treatment in Alabama's taxing scheme. Nonetheless, the decision is hard to take. While this decision resolves the Constitutional question put before it, it creates many issues for the State (and the counties) to now address and hopefully, quickly resolve. This is probably the shortest U.S. Supreme Court opinion I have ever read – however, its impact will be felt in Alabama for a very long time!

1 The figures used in this article were provided by the Legislative Fiscal Office.