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Another California Local Tax Struck Down As Unconstitutional State + Local Tax /29/2003 Client Alert

Following a string of taxpayer victories challenging the constitutionality of local taxes in California, the Stanislaus Superior Court recently struck down Modesto's business license tax as unconstitutional in the case of City of Modesto v. National Med, Inc., No. 292944 (Cal. Super. Ct. filed Aug. 14, 2001) ("Nat'l Med"), because Modesto's tax fails to fairly apportion the receipts of a taxpayer engaged in business inside and outside the city. This article first provides a brief overview of business license taxes in California and the constitutional requirements for such taxes. It then summarizes Nat'l Med, as well as the most recent Los Angeles and San Francisco business license tax apportionment cases. Finally, it addresses several other issues raised in Nat'l Med that could be important in future business license tax cases, such as the proper remedy for unapportioned taxes, limitations on a municipality's right to shorten the statute of limitations on taxpayers' refund claims, limitations on a municipality's ability to enforce its business license tax, and whether a municipality is entitled to invoke the California False Claims Act, which provides for treble damages and attorneys' fees, when litigating business license tax cases.



Authority to Impose Local Taxes

In general, the California Constitution grants charter cities the authority to "make and enforce all ordinances and regulations in respect to municipal affairs …." Cal. Const. art. XI, § 5(a). Referred to as the "home rule" doctrine, this provision provides charter cities with autonomy in the levy of municipal taxes, subject to constitutional limitations and conflicting state statutes of statewide concern. Approximately 90% of California's charter cities have chosen to exercise their home rule authority by imposing a tax on the privilege of engaging in business within their boundaries that is commonly called a "business license" tax.

Business license taxes enacted pursuant to the home rule doctrine may take many different forms and vary among taxing jurisdictions. Typical local business license tax schemes include flat rate taxes or a tax based upon the business's gross receipts, payroll, number of employees or a combination thereof. They may not, however, be levied on a taxpayer's income. Cal. Rev. & Tax. Code § 17041.5. The home rule doctrine also gives cities broad authority to enforce these taxes.

Constitutional Requirements of Local Business License Taxes

Notwithstanding the general power of cities to impose taxes, a local business license tax, like taxes on interstate commerce, must meet four requirements to sustain a challenge under the Commerce Clause of the United States Constitution: (1) it must be applied to an activity with substantial nexus with the taxing jurisdiction, (2) it must be fairly apportioned, (3) it must not discriminate against interstate commerce, and (4) it must be fairly related to the services provided by the jurisdiction. Complete Auto Transit, Inc. v. Brady, 430 U.S. 274 (1977); see also Gwin, White & Prince, Inc. v. Henneford, 305 U.S. 434, 439 (1939) (unapportioned gross receipts tax deemed unconstitutional).

As with state-level taxes, for a local tax to meet the fair apportionment prong of Complete Auto, the local tax must be "internally consistent" and "externally consistent." Container Corp. of Am. v. Franchise Tax Bd., 463 U.S. 159, 169 (1983); see also Dean Milk Co. v. City of Madison, 340 U.S. 349 (1951); Gen. Motors Corp. v. City of Los Angeles, 35 Cal. App. 4th 1736, 1742 (1995). A tax is "internally consistent" when no greater burden would be placed on interstate commerce than intrastate commerce if every other taxing jurisdiction were to impose a tax identical to the one in question. Okla. Tax Comm'n v. Jefferson Lines, Inc., 514 U.S. 175, 185 (1995). A tax is "externally consistent" when a jurisdiction reaches only "that portion of value that is fairly attributable to economic activity within the taxing State." Id. If the tax violates either requirement, it is unconstitutional. Local taxation schemes in California are also subject to these requirements to protect intrastate commerce from overzealous local taxing jurisdictions.

Modesto's Business License Tax

Modesto imposes a business license tax on entities engaged in business within the city. The tax is based on an entity's gross receipts, which are generally defined as the "total amount of the sale price of all sales and the total amount charged or received for the performance of any act, service, or employment for whatever nature it may be, for which a charge is made or credit allowed," less certain specified exclusions. Modesto, Cal., Mun. Code § 6-1.101.

National Med, Inc. ("NMI") was a health maintenance organization that served members throughout California. Over the years, NMI operated from its headquarters in Modesto, as well as branch offices in many other cities, and had employees that worked out of home offices and traveled outside the city as part of their job responsibilities. NMI, like other businesses located in Modesto, was subject to Modesto's business license tax. Modesto hired an outside contingency fee auditor to audit NMI's tax returns for the period January 1996 through June 2000. Following this audit and an administrative hearing, Modesto assessed NMI for more than $1 million in additional taxes and penalties, and filed an action against NMI in the Stanislaus County Superior Court. City of Modesto v. Nat'l Med, Inc., No. 292944 (Cal. Super. Ct. filed Aug. 14, 2001).

Although NMI had asserted from the outset that the City of Modesto's tax was unconstitutional because it taxed activities performed outside its jurisdiction, like a "fox chewing off its trapped foot" (General Motors Corp. v. City and County of San Francisco, 69 Cal. App. 4th 448, 453 (1999)), the city repeatedly changed its arguments in an attempt to justify its imposition of a clearly unconstitutional tax. Modesto initially argued that an apportionment provision was unnecessary because it provided a credit for the amount of taxes paid by a taxpayer operating in multiple cities and thus its taxpayers were not subject to a double tax. The superior court ruled that although this credit might satisfy the internal consistency test, Modesto's business license tax nonetheless failed the external consistency test because it purported to tax all gross receipts, even those derived from activities outside Modesto's jurisdiction.

Midway through the litigation, Modesto apparently recognized the defect in its tax and amended its ordinance to include a provision stating that "apportionment rules shall be established," that the City Council shall adopt "general guidelines for apportionment," and that the Finance Director "may make such rules and regulations for apportionment of the tax as are necessary and desirable to overcome constitutional objections." The court held that this language was no more than a promise to adopt specific apportionment language at some unknown future date, which might or might not comply with constitutional mandates. Consequently, the court concluded that Modesto's tax was void and unconstitutional, and could not be enforced against NMI.

The Los Angeles and San Francisco Cases

Nat'l Med follows two other lines of cases regarding parallel business license taxes in Los Angeles and San Francisco. The first line of cases involved General Motors' successful challenges against the business license taxes Los Angeles and San Francisco imposed upon persons who manufactured and sold, or merely sold, goods through business activities within the city. Gen. Motors Corp. v. City and County of San Francisco, 69 Cal. App. 4th 448 (1999); Gen. Motors Corp. v. City of Los Angeles, 35 Cal. App. 4th 1736 (1995). The courts in these cases held that the taxes, which effectively were imposed on businesses manufacturing outside and selling inside the cities, but not on businesses solely manufacturing and selling inside the cities, were unconstitutional because they violated the internal consistency test and discriminated against out-of-city manufacturers. Gen. Motors Corp. v. San Francisco, 69 Cal. App. 4th at 451; Gen. Motors Corp. v. Los Angeles, 35 Cal. App. 4th at 1740-41.

Following General Motors' victories in the manufacturing-selling tax cases, taxpayers also brought successful challenges against Los Angeles' and San Francisco's alternative gross receipts payroll business license taxes. See, e.g., Union Oil Co. v. City of Los Angeles, 79 Cal. App. 4th 383 (2000). The gross receipts payroll taxes effectively required businesses to pay either a gross receipts tax or a payroll tax to those cities, whichever was higher. In the Los Angeles case, the Court of Appeal held that this taxation scheme violated the internal consistency test, because if an identical tax were imposed by two cities, a taxpayer engaged in business in both cities would be required to pay the gross receipts tax in one city and the payroll tax in the other, whereas a taxpayer engaging in business in only one city would be required to pay only one tax. Id. at 390. In the San Francisco case, the City eventually chose to settle for approximately $60 million, after being faced with a potential liability of $570 million if the case had gone to court, and repealed its tax.

Outstanding Issues

These recent victories are likely to encourage challenges by other taxpayers faced with unconstitutional business license taxes. The remainder of this article focuses on several additional issues raised in Nat'l Med that may also be relevant in future cases.

What Is the Proper Remedy for an Unapportioned Tax?

Following Nat'l Med, Modesto indicated that it only intends to provide harmed taxpayers with a partial refund of the unconstitutional taxes paid, i.e., the difference between the amount paid under the unconstitutional tax and the amount that would have been assessed if the tax had been properly apportioned in the first place. However, the Stanislaus Superior Court, as well as the California Court of Appeal, already has recognized that the proper remedy for an unapportioned tax is a full refund of all taxes paid. See City of Modesto v. Nat'l Med, Inc., No. 292944 (Cal. Super. Ct. filed Aug. 14, 2001); Gen. Motors Corp. v. San Francisco, 69 Cal. App. 4th at 457-58.

Although a complete discussion of the proper remedy for taxes found to be unconstitutional is beyond the scope of this article, in Nat'l Med, a full refund of the amount paid under an unapportioned tax is the proper remedy for several reasons. First, a taxpayer filing a claim for refund has the burden of proving that it is entitled to relief. It may be reasonable for a municipality to require taxpayers to maintain records establishing the extent of their out-of-city activities or double taxation at the time the tax is assessed. However, because there are many ways in which a tax properly can be apportioned, it would be unreasonable to condition a taxpayer's right to relief from an unconstitutional tax on whether that taxpayer fortuitously maintained the records necessary to establish entitlement to relief under apportionment rules that were not in existence during those previous years. See Gen. Motors Corp. v. San Francisco, 69 Cal. App. 4th at 457-58.

Second, public policy also supports a full refund of an unconstitutional tax. If the only risk a municipality faces when its tax eventually is ruled unconstitutional is that it will be required to refund the excess amount over what it may have been entitled to collect, the municipality will have little incentive to correct unconstitutional business license tax without requiring taxpayers to litigate the issue. For both of these reasons, the appropriate remedy in such instances is to hold that unapportioned taxes are void and unenforceable, thus entitling harmed taxpayers to a full refund of all amounts paid.

Can a Municipality Shorten the Statute of Limitations on Taxpayers' Refund Claims?

Shortly before the trial court issued its decision in Nat'l Med, the Modesto City Council passed an ordinance shortening the statute of limitations for taxpayer refund claims from three years to one year and indicated that it would only honor refund claims filed for this new time period. The City's attempt to cut off taxpayer's remedies by shortening the statute of limitations is suspect.

When a governmental agency shortens the period in which a taxpayer must file a claim for refund, it must provide its taxpayers with a reasonable time to file the refund claims that will be lost upon making this amendment. See, e.g., Aronson v. Superior Court, 191 Cal. App. 3d 294, 297 (1987); Rosefield Packing Co. v. Superior Court, 4 Cal. 2d 120, 122-23 (1935). Modesto failed to provide its taxpayers with a reasonable time to file existing claims that otherwise would be eliminated by the amendment. The amendment could violate taxpayers' due process rights if it is allowed to cut off these pre-existing rights, and thus should only be applied on a prospective basis. See id.

To What Extent Can a Municipality Enforce Its Business License Tax?

Charter cities generally have broad authority when enforcing their own business license taxes. Modesto sought to exercise this authority by threatening to use police force to shut down NMI's business within the city unless NMI posted security in the city's favor, even though NMI had timely appealed its administrative decision. In light of this threat, NMI, at considerable cost, was required to post a letter of credit for more than seven times the amount of tax administratively determined to be due.

Upon the letter of credit's expiration, NMI sought a ruling from the Stanislaus Superior Court that it was not required to renew this security. The court agreed, ruling that "[t]he City of Modesto admits that there is no local, State nor National law justifying the in excess of seven million dollar security that the City required to be posted or the City would … request the assistance of the Chief of Police to shut down NMI's business operations in the City of Modesto" and that "since there is no legal authority for such a high demand … NMI need not renew the letter of credit …." This decision makes it clear that even though the home rule doctrine provides charter cities with broad latitude when administering business license taxes, this authority is not unlimited, and their conduct must be authorized by the federal or state constitution, state statutes, or local ordinances. Currently, NMI has an action before the Stanislaus Superior Court seeking damages for the costs of the letter of credit Modesto demanded that NMI post.

May a Municipality Enforce a Local Tax by Bringing an Action Under the California False Claims Act?

In an unprecedented action, Modesto not only filed a claim against NMI for the $1 million in taxes and penalties its Finance Director had stated were due, but also filed a separate claim for an additional $6 million under the California False Claims Act ("CFCA"). The CFCA provides that persons who knowingly present false claims to state or local governments may be liable for three times the amount of damages the government sustained, a civil penalty of $10,000 per false claim, and the cost of bringing the action. Cal. Gov't Code § 12651(a). No California city had previously asserted, and no California court had ever held, that the CFCA could be used against taxpayers for statements made on business license tax returns.

Indeed, a review of the CFCA and its legislative history confirms that the Legislature did not intend for the CFCA to be used as a sword against taxpayers. It specifically states that it does not apply to statements made pursuant to the California Revenue and Taxation Code (similarly, the Federal False Claims Act ("FFCA"), upon which the CFCA is based, states that it is not applicable to statements made pursuant to the Internal Revenue Code). Moreover, the legislative history makes it clear that the CFCA (as well as the FFCA) was aimed at addressing false claims for money through fraud in corporate billing, and not purported improperly filed tax returns.

Application of the CFCA to local tax returns would be problematic for several reasons. First, the definition of "fraud" set forth in the CFCA is broader than that contained in California tax law. Specifically, the CFCA defines fraud as "reckless disregard of the truth or falsity of the information," Cal. Gov't Code § 12650(b)(2), which is a standard that is much lower than the standard contained in civil tax law cases, which requires "actual, intentional wrongdoing, coupled with a specific intent to evade a tax believed to be owing. It implies bad faith and a sinister motive." In re Wickman, 1981 Cal. Tax LEXIS 170, at *6 (State Bd. of Equalization Feb. 2, 1981) (citation omitted); see also In re Brown, 1974 Cal. Tax LEXIS 11 (State Bd. of Equalization Oct. 7, 1974); In re Allec, 1975 Cal. Tax LEXIS 79 (State Bd. of Equalization Jan. 7, 1975); In re Fairchild, 1971 Cal. Tax LEXIS 11 (State Bd. of Equalization Oct. 27, 1971).

Second, the burden of proof for establishing fraud under the CFCA is very different from the burden of proof required in civil tax cases. The CFCA merely requires government to establish fraud by the "preponderance of the evidence," a much easier burden than the government has in civil tax cases, where fraud "is never presumed, but must be established by proof. The presumption always is in favor of good faith, innocence, honesty and fair dealing …." Marchica v. State Bd. of Equalization, 107 Cal. App. 2d 501, 510 (1951). Indeed, in civil tax cases, the taxing authority must prove fraud by "clear and convincing evidence, something impressively more than a preponderance of the evidence," In re Allec, 1975 Cal. Tax LEXIS 79, at *7 (emphasis added), and findings of fraud may "not be sustained upon circumstances which at most create only suspicion." In re Fairchild, 1971 Cal. Tax LEXIS 11, at *4.

Third, the statute of limitations for bringing an action under the CFCA is much longer than the statute of limitations for assessing business license taxes in many municipal codes. For example, at the time Modesto filed its CFCA claim, the statute of limitations for filing an action against a taxpayer pursuant to Modesto's Code was three years, whereas the statute of limitations for filing an action under the CFCA can be as long as ten years. The discrepancy between these limitations periods resulted in Modesto seeking $10,000 per false claim, treble damages, and attorneys' fees for allegedly false statements made during the past ten years, while seeking additional taxes and penalties under its local ordinance for a substantially shorter period of time.

Finally, there are strong policy arguments for rejecting the application of the CFCA to local tax returns. In complex tax cases, some uncertainty often exists as to the proper filing position. In such cases, taxpayers generally are permitted to file where a reasonable basis for that position exists, and are not restricted to positions in which there is absolute certainty. See Crim v. Comm'r, 57 T.C.M. (CCH) 495 (1989). Extending the CFCA to local tax returns would put every person and business who has paid taxes during the last ten years in the precarious position of facing CFCA claims relating to those returns, and potentially subjecting them to the CFCA's treble damages, civil penalties, and attorneys' fees. Whether the CFCA applies to local taxes, including business license taxes, remains an open issue. The Stanislaus Superior Court was not required to resolve this question in Nat'l Med since it held that Modesto's business license tax was unconstitutional, and could not be enforced.

Final Thoughts

Taxpayers have continued to test the constitutionality of business license taxes, and the success of these recent cases is likely to encourage future suits. Nat'l Med provides a sample of tactics a municipality might employ when fighting such cases, and demonstrates that a charter city's authority is not unlimited, even where its tax is enacted pursuant to the home rule doctrine.

[The authors represented National Med, Inc. in this case.]

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