United States: Keep Your Returns Separate, Please: Kentucky law Barring Unitary Returns Upheld as Constitutional

A recently-enacted law which bars the filing of unitary Kentucky returns for tax years ending on or before December 31, 1995 has been held constitutional by the Franklin Circuit Court in Kentucky. In Johnson Controls, Inc. v. Commonwealth of Kentucky, Revenue Cabinet, 00-CI-00523, 00-CI-00661 (Ky.Cir.Ct. (Franklin), Jul. 1, 2004), the effect of the law is to prevent claims for refunds by taxpayers who would have benefited from filing on a unitary rather than a separate-return basis — claims said by the court to be worth $200 million, including interest. An appeal of the circuit court’s July 1, 2004 decision is pending, so stay tuned to this State Tax Return channel for more news as this story develops...

The long-simmering controversy has its roots in Kentucky Revenue Policy 41P225, adopted by the Kentucky Revenue Cabinet (the "Cabinet") in 1988. From 1972 to 1988, the Cabinet allowed the filing of unitary returns, but Policy 41P225 ended that practice by barring unitary returns and requiring the filing of separate returns only. The Cabinet reversed its position and allowed the filing of unitary returns in 1993. In the meantime, however, several corporations challenged 41P225 in court and, on December 22, 1994, the Kentucky Supreme Court struck down the policy in GTE v. Revenue Cabinet.¹ Post-GTE, many taxpayers who had previously filed separate returns would be entitled to lower tax payments when filing amended, unitary returns. The Cabinet began developing settlement guidelines to prepare for these inevitable refund claims.

The Kentucky Legislature did not sit on the sidelines as these events unfolded, but it enacted laws to limit the years for which such unitary returns could be filed. First, in 1996, the legislature enacted H.B. 599, which barred the filing of unitary returns for tax years after December 31, 1995. Unitary returns for tax years prior to that date could still be pursued. In 1998, the legislature adopted H.B. 321, which barred unitary returns filed after December 22, 1994 (the date of the GTE decision) for tax years before December 31, 1995. The Franklin Circuit Court struck down H.B. 321 in Elk River Res. v. Revenue Cabinet and, during the appeal of that decision, H.B. 321 expired in 2000 under its own terms. Thus, the appeal was dismissed as moot.

Finally, in 2000, the legislature enacted H.B. 541, which (1) bars refund claims on unitary returns filed after December 22, 1994, for tax years ending on or before December 31, 1995; and (2) bars the filing of unitary returns for tax years ending before December 31, 1995 unless the corporations filed unitary returns on or before December 22, 1994 for tax years ending before December 31, 1994.²

Several corporations, including Johnson Controls, Inc. ("Johnson Controls"), sued to challenge the constitutionality of H.B. 541 under both the federal and Kentucky constitutions, claiming due process, equal protection, takings and separation of powers violations, along with claims based on Sections 2, 3 and 59 of the Kentucky Constitution.

First, Johnson Controls claimed H.B. 541 violated their constitutional due process rights under McKesson Corp.³ and Gassum⁴ by depriving them of their "post-deprivation (after payment of tax) procedural safeguards." The court dismissed this argument by holding that while the Due Process Clause requires a post-deprivation remedy if a tax statute is ruled unconstitutional, it does not require a post-deprivation remedy for overpaid taxes under a constitutional statute.⁵

The court cited to the United States Supreme Court’s opinion in United States v. Carlton⁶ for the proposition that Due Process Clause principles for retroactive tax legislation require only that the statute be "supported by a legitimate legislative purpose furthered by rational means..." Here, the court found that the retroactive prohibition of unitary returns for the legislative purpose of avoiding "a massive loss of state revenue" met this rational basis test. This is notwithstanding the fact that plaintiffs filed separate returns in detrimental reliance on Policy 41P225, as the court held such detrimental reliance under the Carlton decision "does not result in a constitutional violation." Perhaps the court was influenced by the virtually constant legislation on this issue since the GTE decision.

Similarly, the court held that Carlton’s requirement that the period of retroactivity be modest is also met, as the retroactive period under H.B. 541, 5.5 years, "is not excessive in light of the legitimate governmental purpose it in [sic] designed to achieve—stemming the loss of massive revenues caused by the unitary method for corporate tax returns for pre-1995 years."

The plaintiffs argued that H.B. 541 violated their constitutional equal protection rights in that it "treats them differently from other ‘unitary’ corporate taxpayers." The court disagreed, citing to Yeoman v. Commonwealth Health Policy Bd.⁷ for the proposition that a tax statute need only constitute a "rational means of promoting a legitimate state objective." Agreeing with the Revenue Cabinet, the court held that avoiding a loss of tax revenue is a "legitimate state purpose" and that the statute is a "‘rational means’ to achieve that purpose," as the statute merely sets an "effective date" and treats similarly situated taxpayers differently on either side of this date." Citing again to Carlton, the court stated that raising revenue is a legitimate legislative purpose, and a law that retroactively adds a tax rationally furthers that goal.⁸

The plaintiffs claimed also that H.B. 541 constituted "special legislation" barred by Section 59 of the Kentucky Constitution. That section states that the "[t]he General Assembly shall not pass local or special acts concerning any of the following subjects or for any of the following purposes, namely... (15) To authorize or regulate the levy, assessment or collection of taxes." Under relevant precedent,⁹ the court indicated that legislation would pass muster under Section 59 as long as (1) it applied "equally to all in a class," and (2) there are "distinctive and natural reasons inducing and supporting the classification." Because it determined that (1) H.B. 541 applies equally to all corporations seeking to file pre-1995 unitary returns after December 22, 1994, and to all corporations that filed their pre-1995 unitary returns on or before December 22, 1994; and (2) a "valid nexus" exists between the classification and the legislative purpose of preventing "the massive loss of state revenue," the court held that the law was constitutional under Section 59.

The court rejected a claim by the plaintiffs that H.B. 541 constituted an unlawful taking of private property for public use without just compensation, under either the federal or Kentucky constitutions. Instead, the court indicated that relevant law makes clear that a law that "imposed only a financial burden" without identifying a particular property right cannot constitute a "taking." Because (1) the plaintiffs failed to articulate such a property right, (2) taxpayers have no property rights in the tax code, and (3) Plaintiffs apparently cited no case in support of its claim that legislation which "retroactively eliminates a category of tax returns" is a taking, the court held the plaintiffs’ taking clause claims must fail.

Similarly, the court rejected the plaintiffs’ claims that H.B 541 improperly invaded the power of judicial and executive branches in violation of the separation of powers doctrine in Sections 27 and 28 of the Kentucky Constitution. The court held that H.B. 541 does not affect the judgment of the Kentucky Supreme Court in GTE and, therefore, does not encroach on the judiciary; similarly, because the legislature has the sole power to tax, it "did not tread on executive functions" by amending a tax statute through H.B. 541.

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