Ruling Said To Validate Tax Systems

By Sheila Muto
Wall Street Journal
March 29, 2000

SAN FRANCISCO -- When a Superior Court judge here ruled last week in two separate suits that the city's business-tax system is legal, civic leaders touted it as a win not only for San Francisco, but for the many municipalities throughout the state that use a similar system.

While the ruling sets no binding precedent on other courts, it was welcome news for the city of Los Angeles. In recent months, Eastman Kodak Co., Rochester, N.Y.; Atlantic Richfield Co.,Los Angeles; and Vons grocery stores, a unit of Pleasanton-based Safeway Inc., have sued Los Angeles over the way it sets business taxes, says Deputy City Attorney Miguel Dager.

Most large local and out-of-town companies doing business in Los Angeles or San Francisco must pay a tax on either locally generated gross receipts or on their local payroll, whichever is greater. The plaintiffs contend that the system is unconstitutional because it amounts to "two taxes [a tax on gross receipts and a tax on payroll] and an exemption [from the lesser tax]," a structure similar to the tax systems that were struck down in Los Angeles in 1995 and San Francisco last year.

But Superior Court Judge Ronald Quidachay ruled last week that San Francisco's "taxing scheme ... is not discriminatory on its face as a matter of law." The decision "bodes well for sustaining [Los Angeles's[ current taxing system," says Mr. Dager. If the ruling is upheld after an expected appeal, he says, "there's no way we can lose down here."

In separate lawsuits filed last year, General Motors Corp. and Eastman Kodak sued San Francisco seeking reimbursement for taxes paid on grounds that the city's business tax system still favors certain -- though unnamed -- businesses. Since then, 80 other companies based in San Francisco and outside of it -- including Bechtel Group Inc., Charles Schwab & Co., Costco Wholesale Corp., Hewlett-Packard Co., PG&E Corp. and Safeway have followed suit.

At stake in San Francisco is at least $650 million companies have paid to the city since 1998, when the city revised its tax system in anticipation of losing a legal challenge that indeed prevailed last year. So far, the city has refunded $260,000 in taxes to only one company -- GM, for taxes paid prior to the change in the city's business-tax law. But GM, Kodak and others are challenging the revised tax law as well.

Last week's ruling involved separate requests by GM and Kodak for summary judgments ordering San Francisco to refund them $60,000 and $220,000, respectively, in taxes paid both under the previous and current systems. The city contended that it did not owe a refund of taxes collected prior to 1998 because the companies had failed to file a claim within its 90-day statute of limitations.

However, Judge Quidachay found that GM and Kodak were entitled to refunds of $7,000 and $200,000, respectively, on taxes paid prior to 1998. He ruled that the city's 90-day statute is "void" because it conflicts with state law, which mandates a minimum six-month statute of limitations.

San Francisco City Attorney Louise Renne says her office plans to file for summary judgment tomorrow, asking Judge Quidachay to find the city's business-tax system legal and dismiss GM and Kodak's claims for refunds of taxes paid under the current system.

Charles Ajalat, the Los Angeles lawyer who represents both GM and Kodak, says he will appeal. "When there are two taxes and companies pay one and are then exempt from the other, that's an unconstitutional structure," maintains Mr. Ajalat, who also represents most of the other plaintiffs with suits against San Francisco, as well as the three companies that have sued Los Angeles. "If you apply only one tax to everyone, there wouldn't be this constitutional defect."

It's unclear how many jurisdictions in California have a business-tax structure similar to Los Angeles and San Francisco. Dwayne M. Horii, a Los Angeles lawyer who specializes in local and state tax issues but is not involved with the case, says "most cities use this type of [dual tax] system."

Glen Everroad, legislative coordinator for the California Municipal Business Tax Association, which represents cities and counties that collect taxes from businesses, says 202 of the association's 348 members levy business taxes based on gross receipts, and he estimates that many of those charge a payroll tax if a company generates little or no gross-receipts taxes.

Companies doing business in the city of Oakland are taxed based either on their gross receipts or their payroll, depending on their industry classification, says Terry Brown, an Oakland deputy city attorney. Though Oakland's business-tax system differs slightly from San Francisco's, Mr. Brown calls Judge Quidachay's ruling a "positive" one. It shows, he says, that "the courts are realizing the reality that there are different taxable events," such as payroll and gross receipts.

Los Angeles and San Francisco have been embroiled for a decade in legal challenges to their business-tax systems. In 1990, GM, represented by Mr. Ajalat, sued Los Angeles, challenging the constitutionality of city ordinances that exempted locally based manufacturers from a city sales tax that others had to pay.

In 1995, the state Court of Appeal in Los Angeles found that system illegal, not only because it taxed nonlocal companies more heavily than locals, but also because it threatened those companies with double taxation. A manufacturer based outside Los Angeles might be taxed by its home jurisdiction on all its sales and, in addition, have to pay Los Angeles a tax on sales made there.

(GM also sued San Francisco, which had adopted a similar system. The state Court of Appealin San Francisco ruled for the auto maker last year.)

As a result, Los Angeles and San Francisco amended their business-tax laws: Today, companies pay either a tax on their gross receipts or on their payroll, which ever is greater. Both cities contend they have added safeguards to protect against double taxation. Los Angeles's Mr. Dager says that if an out-of-city company has to pay the payroll tax, it is capped at the firm's gross-receipts tax calculation. San Francisco's Ms. Renne says any company that believes the city is unfairly taxing it under either the gross-receipts or payroll formulas can get the tax amount adjusted.

Under the current system, Los Angeles collects about $300 million annually in business taxes, the third-biggest revenue source for the city's $4 billion budget behind property and sales taxes, says Deputy Mayor Rockard Delgadillo. Taxes based on gross receipts make up the bulk of the business taxes collected.

San Francisco, a combined city-county government with a $4.2 billion budget, collects between $200 million and $218 million annually in business taxes, most of it from payroll taxes. They accounted for 12% of the city's $1.4 billion in tax revenue, compared with 2% from the gross-receipts tax.

Because of its payroll taxes, "San Francisco is the most expensive place to do business in the state," says Larry Kosmont, a Los Angeles-based consultant who tracks business costs in California.

"Business taxes are really the only opportunity the city has to recover the costs of services that make business development possible," responds San Francisco's Ms. Renne.

Says J. Pat Powers, a Palo Alto attorney representing a company that might file suit against San Francisco: "There are some businesses...that are quite sympathetic to the city's revenue needs," but companies "have a duty to shareholders to not pay a tax that's unconstitutional."