Department 29 Superior Court of California County of Sacramento 720 Ninth Street Timothy M. Frawley, Judge Lynn Young, Clerk

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1 Department 29 Superior Court of California County of Sacramento 720 Ninth Street Timothy M. Frawley, Judge Lynn Young, Clerk Hearing: Friday, May 8, 2009, 1:30 p.m. CALIFORNIA TAXPAYERS' ASSOCIATION Case Number: v. CALIFORNIA FRANCHISE TAX BOARD, et al. Proceedings: Petition for Writ of Mandate and Verified Complaint for Injunctive Relief and Declaratory Judgment Filed By: Amy Silverstein, Silverstein & Pomerantz LLP, Attorneys for Petitioner TENTATIVE RULING: Appearances required. This Petition for Writ of Mandate and Verified Complaint for Injunctive Relief and Declaratory Judgment (the "Complaint"), filed by Petitioner California Taxpayers' Association ("CalTax"), challenges the constitutionality of California Revenue and Taxation Code section 19138, which was added by section 5 of Senate Bill X1 28 ("SB X1 28"), and became effective on December 19, Section purports to impose a "penalty" on any corporate taxpayers with an understatement of tax in excess of one million dollars ($1 million) for any taxable year. The penalty is equal to twenty percent (20%) of the total amount of the understatement, which is measured by the difference between the correct tax liability and the tax reported on the taxpayer's "original return." Taxpayers required to be included in a combined report under Revenue and Taxation Code section 25101, or authorized to be included in a combined report under Revenue and Taxation Code section , are combined and treated as a single entity for purposes of determining whether the understatement exceeds $1 million. Section applies retroactively to each taxable year beginning on or after January 1, 2003, for which the statute of limitations on assessment has not expired. However, a taxpayer may reduce the likelihood of an underpayment Page 1 of 8

2 penalty for prior taxable years by filing an amended return. For the taxable years, if a taxpayer files an amended return and pays the tax shown on the amended return by May 31, 2009, the taxpayer may treat the tax shown on the amended return as the tax shown on the "original return" for purposes of determining any understatement of tax. There are two express exceptions to liability under section 19138; no penalty shall be imposed where the understatement is attributable to (1) specified changes in law; or (2) the taxpayer's reasonable reliance on a legal ruling by the Chief Counsel of FTB. The procedures of the Revenue and Taxation Code governing deficiency assessments including the protest and appeal procedures -- do not apply to the assessment and collection of penalties under section Further, section 19138, subdivision (d) provides that a refund or credit for any amounts paid to satisfy a penalty imposed under section "may be allowed only on the grounds that the amount of the penalty was not properly computed by the Franchise Tax Board." Petitioner CalTax is a non-profit organization founded to protect individual and corporate taxpayers from unnecessary taxes and to promote government efficiency. CalTax alleges that included among its members are more than 200 corporations subject to California franchise or income tax laws, many of whom pay franchise or income taxes in excess of $1 million and regularly report or receive assessments of California income or franchise taxes in excess of $1 million in the ordinary course of their businesses. CalTax's Complaint, filed on February 17, 2009, challenges the constitutionality of section The Complaint contains six causes of action. The First Cause of Action alleges that section violates article XIIIA, 3 of the California Constitution because section 19138, while termed a penalty, in substance imposes a tax that was not approved by two-thirds of all members elected to each of the two houses of the Legislature. The Second Cause of Action alleges that section violates article IV, 8(b) of the California Constitution because SB X1 28 (which enacted section 19138) was not "printed and distributed" to the members of the Assembly and Senate before it was passed, and because the Senate failed to "read the bill by title" on three separate days or to dispense with this requirement by a two-thirds roll call vote. The Third, Fourth, and Fifth Causes of Action allege that section violates the Due Process, Equal Protection, and Commerce Clause of the United States Constitution, respectively, because, among other reasons, it (a) affords no prepayment or post-payment review; (b) operates retroactively for an excessive period of time; (c) fails to give clear notice of what conduct it seeks to prohibit; (d) treats individual corporations different than combined groups of "unitary" corporations; and (e) disproportionately burdens Page 2 of 8

3 interstate commerce. The Sixth Cause of Action seeks declaratory relief that section is illegal and invalid for each of the reasons set forth above. CalTax seeks a declaration that section is unconstitutional on its face and a judgment enjoining its enforcement. Respondent Franchise Tax Board ("FTB") previously demurred to the Complaint on the grounds the Court lacks subject matter jurisdiction over the claims and the Complaint fails to allege facts sufficient to constitute a cause of action for injunctive, declaratory, or mandamus relief. Specifically, FTB argued that (1) CalTax lacks standing to bring this lawsuit; (2) CalTax's challenge to section is not ripe for judicial review; and (3) CalTax's claims are barred by the constitutional "pay first, litigate later" rule, the doctrine of exhaustion of administrative remedies, and the doctrine of adequate legal remedies. The Court overruled FTB's demurrer. Discussion The issues presented in this proceeding are as follows: 1. Did the enactment of section violate California Constitution, article XIII A, section 3 ["Proposition 13"] because the "penalty" is, in effect, a "tax" or a "change in State taxes" that was not passed by at least two-thirds of all members of each of the two houses of the Legislature? 2. Did the enactment of section violate California Constitution, article IV, section 8(b) because the Senate dispensed with the constitutional "reading requirement" by resolution without a twothirds roll-call vote, and/or because the bill was not printed and distributed to the members of the Senate and Assembly before voting? 3. Is section facially unconstitutional under the Excessive Fines Clause of the Eighth Amendment because the amount of the purported penalty 20% of the amount of any understatement of tax is grossly disproportionate to the gravity of the "offense?" 4. Is section facially unconstitutional under the substantive due process guarantees of the Fourteenth Amendment because it fails to give fair warning of the conduct it requires and/or because it applies retroactively to each taxable year beginning on or after January 1, 2003? 5. Is section facially unconstitutional under the procedural due process guarantees of the Fourteenth Amendment because it denies any pre- or post-payment review and therefore does not provide taxpayers with a fair opportunity to contest the legality of the penalty? 6. Is section facially unconstitutional under the Commerce Clause because it discriminates against multi-state corporations by Page 3 of 8

4 employing a more favorable method for determining when the levy applies for intra-state corporations than for inter-state corporations? 7. Is section facially unconstitutional under the Equal Protection Clause because it discriminates against inter-state businesses in favor of similarly situated intra-state businesses? The Court addresses each issue separately below. A. California Constitution, article XIII A, section 3 [Proposition 13] CalTax alleges that section 19138, although nominally a "penalty," is, in fact, a "tax," constitutionally required to be passed by at least two-thirds of the members of each house of the Legislature. Because it is undisputed that section was not passed by two-thirds of the members of the Assembly and Senate, CalTax alleges section violates article XIII A, section 3 of the California Constitution. As an initial matter, the Court must decide which party has the burden of proof in determining whether the levy is a valid penalty or an unconstitutional tax. The Court is not aware of any cases directly deciding this issue, although a number of courts have wrestled with the issue of who has the burden of proof in determining whether an imposition is a valid fee or an unconstitutional tax, with varying results. (See Sinclair Paint, supra, at pp [suggesting persons challenging fees have burden of establishing invalidity]; Sea & Sage Audobon Soc'y v. Planning Com. (1983) 34 Cal.3d 412, 421 [finding plaintiff had initial burden of presenting a prima facie evidentiary showing as to the invalidity of the fee]; Beaumont Investors v. Beaumont-Cherry Valley Water Dist. (1985) 165 Cal.App.3d 227, [local agency seeking to invoke exception to Proposition 13 held to have burden of establishing fee fits the exception]; City of Dublin v. County of Alameda (1993) 14 Cal.App.4th 264, [same]; Bixel Assocs. v. City of Los Angeles (1989) 216 Cal.App.3d 1208, 1216 [same]; Knox v. City of Orland (1992) 4 Cal.4th 132, [refusing to apply Beaumont to case involving benefit assessments], superseded by statute as stated in Not About Water Com. v. Board of Supervisors (2002) 95 Cal.App.4th 982; San Diego Gas & Elec. Co. v. San Diego Air County Pollution Control Dist. (1988) 203 Cal.App.3d 1132, 1146 [requiring government to prove estimated costs of the regulatory activity, and the basis for determining manner in which the costs are apportioned,], cited with approval in Sinclair Paint, supra; California Ass'n of Prof. Scientists v. Dept. of Fish & Game (2000) 79 Cal.App.4th 935, 945 [following Beaumont]. In this Court's view, the cases concluding that the government bears the burden of proof are distinguishable on their facts. They involve situations where the government was attempting to avoid a general restriction on "special taxes" by invoking a legislative exception. Under those circumstances, courts held the Page 4 of 8

5 government should have at least the initial burden of showing that the challenged fee fits the exception. In this case, in contrast, there is no presumption that the "penalty" is an unconstitutional tax and the government is not seeking to avoid a general rule against tax penalties. As a result, the Court finds no compelling reason to deviate from the traditional rule that the plaintiff has the burden of establishing the levy is invalid. CalTax has not met its burden of proof in this case. Even if the character of a tax is ascertained from its incidents, not its label, the Court is mindful that taxes and penalties both may simultaneously serve penal and revenue-raising purposes and that it is a slippery business for courts to weigh the relative importance of each and determine which is the "primary" purpose. Thus, while courts may be required to determine whether an exaction is a "penalty" or a "tax," courts must do so carefully and should overturn the legislative designation only where the nature of the exaction is clearly incompatible with its label. Here, the Court is not persuaded that the exaction is clearly a tax. Not only does the Legislature refer to the exaction as a penalty, the exaction operates as a penalty in that only taxpayers with an understatement of tax in excess of one million dollars are subject to the exaction. In other words, the exaction is imposed as "punishment" for understating taxes. CalTax argues that many large, multi-state taxpayers routinely will be subject to the penalty and therefore, as to them, the exaction is akin to a tax. But this is an argument that the exaction discriminates against large, multi-state taxpayers, and is not, by itself, proof that the exaction is a tax. CalTax has not met its burden to prove that section violates Proposition 13. B. California Constitution, article IV, section 8(b) CalTax also argues that the enactment of section is unconstitutional because the Legislature failed to adhere to the procedures required by article IV, section 8(b) of the California Constitution, namely the "reading" and "printing and distribution" requirements. FTB argues that CalTax's challenge must be denied because the "enrolled bill" is incontrovertible proof that the bill was constitutionally enacted and the validity of the bill cannot be impeached by resort to the legislative journals. There is historical support for FTB's position, but the trend is away from the conclusive presumption toward a rule that the enrolled bill is entitled only to a prima facie presumption of validity, which may be attacked where the legislative journal shows that the constitutional requirements for enactment of the statute Page 5 of 8

6 were not followed. (See People ex rel. Levin v. County of Santa Clara (1951) 37 Cal.2d 335, ) On the other hand, the doctrine of substantial compliance has been held to suffice under some circumstances. (Id. at p. 341.) At this time, the Court has no tentative ruling on this issue. At oral argument, the parties are directed to be prepared to address (1) how the "Enrolled Bill Rule" applies to this case; and (2) whether the facts presented show substantial compliance. C. The Excessive Fines Clause CalTax's claim that section violates the Excessive Fines Clause of the U.S. Constitution is denied. CalTax bears a heavy burden in attempting to demonstrative that section is unconstitutional on its face. A facial challenge to the constitutional validity of a statute considers only the text of the measure itself, not its application to the particular circumstances of an individual. To support a determination of facial unconstitutionality, voiding the statute as a whole, a plaintiff cannot prevail by suggesting that in some future hypothetical situation constitutional problems may possibly arise as to the particular application of the statute. Rather, a plaintiff must demonstrate that the act's provisions "inevitably pose a present total and fatal conflict with applicable constitutional prohibitions," i.e., that the law is incapable of any valid application. (Pac. Legal Found. v. Brown (1981) 29 Cal.3d 168, ) A civil penalty such as the one here is, by virtue of its punitive purpose, a fine for purposes of the Eighth Amendment. (San Francisco v. Sainez (2000) 77 Cal.App.4th 1302, 1321.) The question is whether it is excessive. In general, a fine is considered excessive if it is "grossly disproportional" to the gravity of the offense. (United States v. Bajakajian (1998) 524 U.S. 321, 334.) Thus, the touchstone of the constitutional inquiry is proportionality, which is assessed by examining the nature of the "offense" and its relationship to the penalty imposed; the penalties imposed for like offenses; the defendant's culpability; and the defendant's ability to pay. (People ex rel. Lockyer v. R.J. Reynolds Tobacco Co. (2005) 37 Cal.4th 707, ) This is a heavily fact intensive inquiry. CalTax has not met its burden to show that section is unconstitutional on its face though the Court does not foreclose the possibility that section may be found to be unconstitutional as applied to a particular taxpayer. Page 6 of 8

7 D. Substantive Due Process The Court also denies CalTax's claims that section violates the substantive due process guarantees of the Fourteenth Amendment because it is vague and retroactive. Due Process requires that laws give the person of ordinary intelligence a reasonable opportunity to know what is prohibited, so that he may act accordingly. (Grayned v. City of Rockford (1972) 408 U.S. 104, 109.) In this case, however, it is clear what is prohibited: understatements of taxes in excess of $1 million. Thus, the statute gives fair warning of the conduct it requires, even if, as CalTax contends, it is difficult to comply or encourages over-compliance. Whether the penalty violates substantive due process because it is retroactive depends on whether the retroactive application is so "harsh and oppressive" as to transgress the constitutional limitations. (United States v. Carlton (1994) 512 U.S. 26, 31-32; City of Modesto v. National Med., Inc. (2005) 128 Cal.App.4th 518, ) If the retroactive application of the legislation is justified by a "rational legislative purpose," and the period of retroactivity is "modest," the legislation will comply with due process. (Id.) Here, the Legislature had a rational legislative purpose to make the penalty retroactive to encourage those taxpayers who filed returns in which they took "questionable positions" to come forward and amend their returns. (See Licari v. Commissioner (9th Cir. 1991) 946 F.2d 690, 693.) While a period of retroactivity longer than the year preceding the legislative session normally would raise constitutional issues, in this case, the constitutional concerns are allayed by taxpayers' right to file an amended return, which shall be treated as the original return for purposes of determining the penalty. The Court does not find the retroactive application of the penalty to be so harsh and oppressive as to transgress the constitutional limitation of the substantive due process clause. E. Procedural Due Process The Constitution requires that government provide a procedure which, at some point, provides the taxpayer a meaningful opportunity to contest the legality of a tax penalty. (City of Modesto, supra, 128 Cal.App.4th at p.529; Batt v. City and County of San Francisco (2007) 155 Cal.App.4th 65, 72; see also McKesson Corp. v. Div. of Alcoholic Bevs. & Tobacco (1990) 496 U.S. 18, 38-39, [where taxpayers are required to pay first, federal Due Process requires the government to provide a "clear and certain" post-deprivation procedure to challenge the validity of the tax].) Whether a state chooses to provide pre- Page 7 of 8

8 deprivation process (e.g., an injunction) or instead afford post-deprivation relief (e.g., a refund) is a matter left to the state's discretion. (Batt, supra, at p.73.) In this case, however, section violates taxpayers' procedural due process rights because it affords no pre- or post-payment review, except on the grounds that the amount of the penalty was not properly computed by FTB. (Rev. & Tax. Code 19138(d), (e) [refund claim may be allowed only on grounds the amount of the penalty was not properly computed]; [limiting judicial action to grounds set forth in claim for refund].) CalTax has persuaded the Court that taxpayers lack a constitutionally adequate remedy in which to challenge the penalty. Accordingly, the portion of section purporting to limit the grounds upon which a refund claim may be allowed is unconstitutional and unenforceable. However, the Court is not necessarily persuaded that this renders section void in its entirety. At oral argument, the parties should be prepared to discuss whether it is possible to reform the statute to preserve it against invalidation under the Constitution. F. Commerce Clause CalTax's Commerce Clause claim is denied. First, CalTax's challenge is more properly directed to Revenue and Taxation Code section , not section Second, even if the claim is construed as a challenge to section 19138, CalTax has failed to show that section facially discriminates against interstate commerce. A statute that has only incidental effects on interstate commerce must be upheld unless the burden imposed on interstate commerce is "clearly excessive" in relation to the putative local benefits. (Pacific Merchant Shipping Assn. v. Voss (1995) 12 Cal.4th 503, 517.) This is a high burden and it has not been met in this case. (See Container Corp. of America v. Franchise Tax Bd. (1981) 117 Cal.App.3d 988, 995 [noting formula for allocation of taxable income of unitary enterprise has been held not to impermissibly burden interstate commerce].) G. Equal Protection Clause CalTax's Equal Protection claim is based on the same "discrimination" alleged in its Commerce Clause claim. CalTax argues that such discrimination renders the statute "wholly arbitrary." However, CalTax has failed to show that the classification in section between taxpayers required to be included in a combined report, and those that are not, is not rationally related to a legitimate governmental purpose (namely, applying the $1 million threshold on a collective basis where multiple taxpayers are engaged in a single, unitary business). Accordingly, the Court rejects CalTax's Equal Protection claim. Page 8 of 8