There are many limitations on California’s power to tax income derived from sources outside of California. Jurisdictional and constitutional questions are present that may restrict states and the federal government by statute also can regulate states ability to raise taxes.
The Commerce Clause of the United States Constitution does not restrict states in taxing interstate commerce. However, case law has established certain principles in determining the validity of state taxation of interstate commerce.
Interpretation of the Commerce Clause in the nineteenth century held that any interstate commerce was immune from state taxation. Direct taxes were regarded as an undue burden on commerce between states. Not until 1977 did the Supreme Court issue a definitive statement on the issue. In Complete Auto Transit v. Brady, 430 U.S. 274 (1977), the Court applied a four-pronged test to validate state taxation of interstate commerce. The tax must:
1. Be applied to an activity with substantial nexus to the taxing state
2. Be fairly apportioned
3. Not discriminate
4. Be fairly related to the services provided by the state.
The substantial nexus requirement is met when a business is located or present within a state. Fairly apportioned requires use of a formula allocating the tax base between jurisdictions in a fair manner. The discrimination requirement is applicable in cases when a company is subject to multiple taxation e.g. more than one state taxes the same income. Fairly related to services provided covers police, fire protection and advantages of a civilized society. It is unlikely a company could challenge a tax on grounds it was not provided these services.
The import-export clause of the Constitution restricts the states ability to tax income from foreign commerce. But in the same analysis, the tax is valid if the commerce clause tests are met, the tax is applied to all businesses in the state and it is not a special protective tariff.
Another constitutional issue is found in the Fourteenth Amendment. The due process clause as interpreted by the Supreme Court requires a connection between the interstate activity and the state, and a rational relationship between the income attributable to the state and intrastate values of the enterprise. These requirements are generally satisfied by a sufficient nexus existing between the state and the entity taxed.
Further limitations exist because of the sovereign immunity doctrine. States may not tax federal instrumentalities or income derived from them. The State of California has avoided this by considering the tax on corporations to be a tax imposed on the corporate franchise, its right to do business, and not on its income. Therefore, income from federal obligations can be included in the tax base.
Statutory limitations result from Congressional action restricting state taxation of income from sale of goods in interstate commerce when certain activities are limited. Public Law 86-272 prohibits any state tax imposed when the business limits its activity to solicitation of orders and no substantial other business takes place. Also, the company cannot have any inventory stored or maintain an office within the state if protection under PL 86-272 is to be achieved.
Stephen Sears is a Certified Public Accountant (CPA) and an investment advisor with a Masters degree in Taxation. He has a Bachelor’s degree in Business Administration. Mr. Sears has been the featured speaker at hundreds of seminars and has been intereviewed countless times on television and radio.
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