Hunt-Wesson, Inc. v. Franchise Tax Board of California

Background

A company that did business in many states had interest expenses and also received dividends from an unrelated foreign subsidiary. California uses a unitary income system that taxes a share of a company’s overall business income based on in-state property, payroll, and sales. California’s law let companies deduct interest except that the deduction was cut by the amount of interest and dividends from unrelated, out-of-state businesses that California could not otherwise tax.

Reasoning

The Court asked whether that deduction cut was a lawful allocation or an unconstitutional way to tax income outside California. Relying on past decisions about when states may tax interstate income, the Court found California’s rule effectively taxed income that had no meaningful connection to the State. The opinion explained the rule assumed too much — it treated all borrowing as if it supported the unrelated business — and said reasonable allocation methods exist elsewhere, like ratio or tracing formulas. Because California’s approach did not actually reflect how income is generated, it violated the Constitution’s Due Process and Commerce protections.

Real world impact

The Court reversed the state court and sent the case back for further proceedings consistent with this opinion. As a result, California cannot enforce that absolute deduction limitation. The decision requires California (and informs other States) to use realistic allocation methods when dividing interest expense between taxable in-state business and untaxable out-of-state business, rather than the absolute, presumptive approach the Court rejected.