United States: Oklahoma Supreme Court Holds Capital Gains Deduction Statute Does Not Violate Commerce Clause

In a 5-4 decision, the Oklahoma Supreme Court has reversed the Oklahoma Court of Civil Appeals and held that the state's capital gains deduction statute does not violate the Commerce Clause of the U.S. Constitution.¹ Specifically, the statute imposes a shorter holding requirement to receive the capital gains deduction upon companies with their primary headquarters in Oklahoma versus companies with their primary headquarters outside Oklahoma. The Court held that there is no discrimination against interstate commerce to which the Commerce Clause applies. Furthermore, the Court held that even if the Commerce Clause applied to this case, the deduction does not facially discriminate against interstate commerce, does not have a discriminatory purpose and has no discriminatory effect on interstate commerce.

Background

The taxpayer, CDR Systems Corporation (CDR), which was doing business in Oklahoma and headquartered in Florida, entered into a stock purchase agreement, selling all of its assets, which it had owned for more than three years. Following the asset sale, CDR filed its 2008 amended Oklahoma corporation income tax return, claiming the Oklahoma capital gains deduction for the gains from the sale of its assets. The Oklahoma Tax Commission denied the deduction, applying a five-year holding period requirement to CDR because it was not considered an "Oklahoma company" pursuant to the capital gains deduction statute. CDR timely filed a protest, arguing that the three-year holding period applicable to an "Oklahoma company" created an unconstitutional disparity between the treatment of in-state versus out-of-state entities. Based on the Administrative Law Judge's recommendation, the Commission denied the protest and CDR subsequently appealed the matter directly to the Court of Civil Appeals.

In its initial decision,² the Court of Civil Appeals determined that the longer holding period requirement for out-of-state companies to take the capital gains deduction than companies with Oklahoma headquarters violated the Commerce Clause of the U.S. Constitution.³ The Court reached this result by concluding that the capital gains deduction was discriminatory on its face, and was "per se invalid" due to the different holding period requirements based on the location of the company's headquarters. Further, the Court found that the law did not survive a "strict scrutiny" analysis with respect to why the differential treatment should be allowed. However, the Court's initial decision did not state a specific remedy to cure the unconstitutional defect in the statute.

Upon rehearing,⁴ the Court of Civil Appeals reconsidered and affirmed its prior decision, but the second opinion elaborated on the appropriate remedy for the taxpayer claiming the constitutional violation and similarly situated taxpayers, allowing retroactive relief. The Commission appealed to the Oklahoma Supreme Court.

Capital Gains Deduction

Under Oklahoma law, a capital gains deduction is provided if there is a sale of real property or tangible personal property located in the state that is owned by a corporation for at least five years prior to the date of the transaction from which the net capital gains arise.⁵ Also, a capital gains deduction is available for the sale of real, tangible or intangible property located within Oklahoma as part of the sale of all or substantially all of the assets of an Oklahoma company and used for at least three years prior to the date of the transaction producing the net capital gains.⁶ "Oklahoma company" is defined as an entity with primary headquarters located in Oklahoma for at least three uninterrupted years prior to the date of the transaction from which the net capital gains arise.⁷

Commerce Clause Does Not Apply to Case

The Commerce Clause authorizes Congress to regulate commerce among the states. As explained by the U.S. Supreme Court, "[t]he negative or dormant implication of the Commerce Clause prohibits state taxation or regulation that discriminates against or unduly burdens interstate commerce and thereby 'imped[es] free private trade in the national marketplace.'"⁸

In determining that the dormant Commerce Clause does not apply to the Oklahoma statute, the Oklahoma Supreme Court thoroughly considered a U.S. Supreme Court case, General Motors Corp. v. Tracy. This case concerned the imposition of sales and use tax on natural gas and an exemption for certain "natural gas companies." The exemption applied to local distribution companies located in Ohio, but did not apply to non-local distribution companies, including producers and independent marketers. The U.S. Supreme Court upheld the exemption and found that the local distribution companies provided a product consisting of gas bundled with services and protections, which was different from the unbundled natural gas provided by the independent gas marketers. There is a threshold question as to whether the companies are considered to be similarly situated for constitutional purposes. If the entities serve different markets, eliminating the disputed tax would not serve the dormant Commerce Clause's fundamental objective of preserving a national market undisturbed by any preferential advantages provided by a state to its residents.

The Oklahoma Supreme Court explained that the Oklahoma deduction is available to a qualifying entity in any market or industry regardless of whether it participates in interstate commerce or intrastate commerce. In contrast to the more ordinary Commerce Clause challenges where a state unfairly taxes out-of-state businesses, the challenge in this case involved a statute intended to encourage businesses to operate in the state. Thus, the Court held that "[w]ithout any actual or prospective competition in a single market, there is no negative impact on interstate commerce that results from the application of this deduction and no discrimination against interstate commerce to which the dormant commerce clause applies."

No Facial Discrimination Against Interstate Commerce

The Oklahoma Supreme Court held that the statute does not facially discriminate against interstate commerce because the deduction is available regardless of whether a company is considered to be an in-state or out-of-state company. CDR unsuccessfully argued that the U.S. Supreme Court's decision in Fulton Corp. v. Faulkner⁹ supported its position that the Oklahoma deduction facially discriminates against interstate commerce. In Fulton, the Court invalidated a North Carolina intangibles tax that was inversely proportional to a corporation's exposure to the state's income tax. The Oklahoma Supreme Court determined that Fulton was distinguishable from the instant case because the North Carolina tax actively discouraged companies from participating in interstate commerce by basing the tax liability on the proportion of in-state activity to out-of-state activity. For purposes of the Oklahoma statute, the extent to which the entity participated in interstate commerce is not relevant to whether the entity qualifies for the deduction. The Oklahoma deduction does not facially discriminate against interstate commerce because it does not penalize the out-of-state activities of corporations doing business in Oklahoma.

No Discriminatory Purpose

According to the Oklahoma Supreme Court, the capital gains deduction does not have a discriminatory purpose because the legislature enacted the legislation to promote significant business investment in Oklahoma. The deduction is intended to encourage out-of-state businesses to locate in the state and does not constitute economic protectionism. CDR did not present any evidence to demonstrate that the legislature had an impermissible motive in enacting the deduction.

No Discriminatory Effect on Interstate Commerce

The Oklahoma Supreme Court held that there is no discriminatory effect on interstate commerce because the deduction did not preclude CDR from making a tax-neutral decision to sell its assets. CDR did not begin conducting business in Oklahoma because of any particular tax incentive provided by Oklahoma law. All decisions made by CDR were made solely on the basis of nontax criteria. Therefore, the U.S. Supreme Court's case holding that a statute violates the Commerce Clause if it precludes tax-neutral decisions¹⁰ was not applicable. Furthermore, there was no prohibited "coercive relocation." In Pike v. Bruce Church, Inc.,¹¹ the U.S. Supreme Court found that an official's order under an Arizona statute unconstitutionally burdened interstate commerce because it forced the taxpayer to incur a loss by requiring it to relocate its packing plant from California to Arizona. In the instant case, there was no evidence that CDR considered relocating to receive the deduction when it sold its assets. CDR's hypothetical speculation about the cost an out-of-state company might incur in locating its primary headquarters in Oklahoma could not support a determination that the deduction discriminated against interstate commerce.

According to the Oklahoma Supreme Court, the deduction has a legitimate purpose of encouraging the growth and development of interstate commerce. The primary headquarters requirement ensures that the gains which qualify for the deduction have nexus to property located within Oklahoma's taxing jurisdiction. Finally, even if CDR could prove that the deduction burdened interstate commerce, the Court would be unable to determine whether the burdens were excessive in relation to the local benefits.

Dissent

Four justices joined in a very detailed dissent arguing that the capital gains deduction is facially discriminatory or at least discriminatory in effect against interstate commerce and violates the dormant Commerce Clause. Also, the dissent disagreed with the majority's reliance on General Motors Corp. v. Tracy. The majority interpreted this case to mean that competition in a single market by similarly situated entities is a requirement for finding discrimination against interstate commerce. However, other cases discussed by the majority, such as Fulton Corp. v. Faulkner, found a dormant Commerce Clause violation even though there was no competition in any single market.

As explained by the dissent, the statute should be subject to the strictest scrutiny because it discriminates against interest commerce on its face or in its practical effect. In this situation, a statute is "per se invalid" and can only be overcome by a showing it advances a legitimate local purpose that cannot be served by reasonable nondiscriminatory alternatives. According to the dissent, the Commission did not meet its burden of proof under the strict scrutiny test. The dissent concluded that "[t]he primary headquarters requirement places a discriminatory burden on interstate commerce by inducing companies to move their primary headquarters to Oklahoma and discouraging companies in Oklahoma from moving their primary headquarters out-of-state, even if those functions could be more efficiently performed elsewhere."

Commentary

The Oklahoma Supreme Court's decision is notable in that by a single vote, it reversed two prior decisions of the Oklahoma Court of Civil Appeals and eliminated the ability of similarly situated taxpayers to pursue refund claims with respect to the capital gains deduction. Typically, a dormant Commerce Clause analysis calls for the application of the U.S. Supreme Court's Complete Auto four-part test.¹² In dismissing the dormant Commerce Clause challenge, the majority opinion did not even make a passing reference to the Complete Auto test, which encapsulates the analysis necessary to determine whether the dormant Commerce Clause is implicated in state tax matters. In contrast, the dissent supported the taxpayer's contention that the third prong of the Complete Auto test (discrimination against interstate commerce) was violated. The analysis applied by the majority placed the burden of proof on CDR. In contrast, the dissent would employ a strict scrutiny test and the Commission would have the burden of proof.

The majority's approach makes it more difficult for a taxpayer to challenge a statute under the Commerce Clause. An argument can be made that existing case law better supports the dissent's methodology and this type of burden on commerce has been declared to be virtually per se illegal.¹³ The majority's approach further complicates the analysis that should be applied in a Commerce Clause challenge. It will be interesting to see whether the taxpayer decides to appeal this decision rife with constitutional principles to the U.S. Supreme Court.

Footnotes

1 CDR Systems Corp. v. Oklahoma Tax Commission, Oklahoma Supreme Court, No. 109886, Apr. 22, 2014.

2 CDR Systems Corp. v. Oklahoma Tax Commission, Oklahoma Court of Civil Appeals, No. 109886, Jan. 17, 2013. For a discussion of this case, see GT SALT Alert: Oklahoma Court of Appeals Holds Capital Gains Deduction Statute Violates Commerce Clause.

3 Following the issuance of the Court's initial decision, the Oklahoma Tax Commission released instructions on how to file an Oklahoma Capital Gain Claim for Refund.

4 For a discussion of this opinion, see GT SALT Alert: Oklahoma Court of Civil Appeals Again Addresses Constitutionality of Capital Gains Deduction.

5 OKLA. STAT. tit. 68, § 2358(D)(2)(a)(1).

6 OKLA. STAT. tit. 68, § 2358(D)(2)(a)(3). Note that the deduction also applies to the sale of stock or an ownership interest in an Oklahoma company owned by a corporation for at least three years prior to the date of the transaction from which the net capital gains arise. OKLA. STAT. tit. 68, § 2358(D)(2)(a)(2).

7 OKLA. STAT. tit. 68, § 2358(D)(2)(c).

8 General Motors Corp. v. Tracy, 519 U.S. 278 (1997) (citations omitted).

9 516 U.S. 325 (1996).

10 See Boston Stock Exchange v. State Tax Commission, 429 U.S. 318 (1977).

11 397 U.S. 137 (1970).

12 In Complete Auto Transit Inc. v. Brady, 430 U.S. 274 (1977), the U.S. Supreme Court developed a four-part test to determine whether a state's imposition of a tax satisfies the Commerce Clause. To meet the test, the tax must (1) be applied to an activity with a substantial nexus with the taxing state, (2) be fairly apportioned, (3) not discriminate against interstate commerce and (4) be fairly related to the service provided by the state.

13 Pike v. Bruce Church, Inc., 397 U.S. 137 (1970); Boston Stock Exchange v. State Tax Commission, 429 U.S. 318 (1977).

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