On January 17, the Oklahoma Court of Appeals determined that the state's capital gains deduction statute impermissibly violated the Commerce Clause of the U.S. Constitution by facially discriminating against non-Oklahoma companies or companies without headquarters located in the state.1 Specifically, the statute imposed a shorter holding requirement to receive the capital gain deduction upon companies with headquarters in Oklahoma versus companies without headquarters in the state.

Background

The taxpayer, CDR Systems Corporation (CDR), an S corporation manufacturer of polymer concrete and fiberglass handholes and pads for utilities, housed its headquarters in Florida and had a manufacturing facility in Oklahoma. CDR entered into a stock purchase agreement, selling all of its assets, which it had owned for more than three years. The purchaser elected to treat the stock purchase as an asset sale under the Internal Revenue Code.

CDR filed its 2008 amended Oklahoma corporation income tax return, claiming the capital gains deduction for gains exceeding $49 million from the sale of its assets. When apportioned, this deduction ultimately resulted in the exclusion of more than $3 million from Oklahoma taxable income.2 The Oklahoma Tax Commission denied the deduction and CDR timely filed a protest. Based on the Administrative Law Judge's recommendation, the Oklahoma Tax Commission denied the protest and CDR subsequently appealed the matter directly to the Court of Appeals.

The issue before the Court was whether the longer holding period requirement for outof- state companies to take the capital gains deduction than companies with Oklahoma headquarters violated the Privileges and Immunities Clause, the Equal Protection Clause, or the Commerce Clause of the U.S. Constitution.

Oklahoma Capital Gains Deduction Violates Commerce Clause

A deduction from Oklahoma taxable income is available for taxable years beginning after December 31, 2005 to corporations for "qualifying gains" (net capital gains) which are generated in three different circumstances:

  • The sale of real property or tangible property located in Oklahoma owned by a corporation for at least five years prior to the date of the transaction from which the net capital gains arise.3
  • 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 arise4 (the term "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).5
  • 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 where such property has been owned by such entity owned by the owners of such entity, and used in or derived from such entity for at least three years prior to the date of the transaction from which the net capital gains arise.6

CDR asserted that the longer holding period for non-Oklahoma companies, as compared to Oklahoma companies, unconstitutionally discriminated against non-resident taxpayers.

Privileges and Immunities Clause

First, the Court addressed CDR's claim that the statute in question violated the Privileges and Immunities Clause because it discriminated against citizens of other states without "substantial reason." The Court rejected that claim based on its determination that longstanding U.S. Supreme Court precedent has held that commercial corporations, such as CDR, are not within the class of protected "citizens."7

Equal Protection Clause

Second, the Court determined that CDR failed to provide any information showing that the application of the capital gains deduction statute violated the Equal Protection Clause by impermissibly discriminating against non-residents. Rather, CDR merely cited a U.S. Supreme Court decision which addressed the taxation of out-of-state insurance companies versus in-state companies.8

Commerce Clause

Finally, the Court considered CDR's Commerce Clause claim. The Commerce Clause restricts a state's regulation of interstate commerce and prohibits a "state tax that favors in-state business over out-of-state business for no other reason than the location of its business."9 The U.S. Supreme Court has found that there are two types of laws that fall under Commerce Clause scrutiny: (i) laws that are discriminatory against interstate commerce; and (ii) laws that only have an "incidental" effect on interstate commerce.10 The discriminatory laws are "per se invalid," whereas the laws with an "incidental" effect on interstate commerce are valid unless their burden on interstate commerce is clearly excessive relative to the local benefits.11

The Court found that the law at issue was discriminatory on its face and, as a result, "per se invalid." The Court reasoned that the law treats Oklahoma companies differently than out-of-state companies for similar taxable events because it provides for a three-year holding period for sales of stock or substantially all the assets owned by an "Oklahoma company," but a five-year holding period applies to the sale of "real property or tangible personal property" by an out-of-state company.12 That is, an Oklahoma company or "an entity whose primary headquarters have been located in Oklahoma for at least three uninterrupted years prior to the date of the transaction from which the net capital gains arise," can qualify for a capital gains deduction when it holds its property being sold (stock or substantially all its assets) for a three-year period, while an out-of-state company can qualify only after holding the "real property or tangible personal property" for a five-year period. In essence, a company without a headquarters located in Oklahoma is required to make a longer-term investment in the state in order to take advantage of the capital gains deduction.

This type of facial discrimination invokes the Court's "strictest scrutiny" of the state's purported legitimate local purpose and assertion that non-discriminatory alternatives are unavailable.13 The Tax Commission argued that the headquarters requirement was legitimately aimed at increasing investment in Oklahoma. The Court did not find merit in this argument, instead determining that the statute did not encourage long-term investment. For instance, an Oklahoma company with headquarters in the state, selling only one of several in-state plants it has owned for more than three years, but less than five years, does not qualify for the capital gains deduction while it would qualify for the deduction if it sold all (not just one) of its in-state plants after the five-year period had expired. Thus, the reason for the differential treatment did not survive strict scrutiny, and the Court ruled that the statute violated the Commerce Clause.

Commentary

Typically, dormant Commerce Clause analyses call for the application of the U.S. Supreme Court's Complete Auto four-part test.14 Here, the Court summarily reached a finding of discrimination and did not even make passing reference to the Complete Auto test. In addition, the Court did not address a potentially important distinction between the three-year and five-year holding periods. The three-year holding period applies to the sale of stock or substantially all of the assets of an Oklahoma company, whereas the five-year period applies to the sale of real or tangible personal property, but not to the sale of intangibles such as stock.

As a result of the Court's decision, a relatively limited class of taxpayers may now be eligible for refunds, pending a potential appeal by the state. Out-of-state taxpayers that have sold a significant amount of Oklahoma property that was held for more than three years but less than five years may consider filing amended returns to protect their rights to a potential refund. However, due to the Court's failure to state a specific remedy to cure the unconstitutional defect in the statute, the state may decide upon avenues that would allow them to effectively avoid processing or paying refunds.

Footnotes

1 CDR Systems Corp. v. Oklahoma Tax Commission, Oklahoma Court of Civil Appeals, Case No. 109,886, Jan. 17, 2013.

2 CDR applied the Oklahoma apportionment factor of 7.1606 percent to the total gains received.

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

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

5 OKLA. STAT. tit. 68, § 2358.D.2.c.

6 OKLA. STAT. tit. 68, § 2358.D.2.a.(3).

7 The Court cited, for example, Monnell v. Department of Social Services, 436 U.S. 658 (1978).

8 Metropolitan Life Insurance Co. v. Ward, 470 U.S. 869 (1985).

9 American Trucking Ass'ns, Inc. v. Scheiner, 483 U.S. 266 (1987).

10 Oregon Waste Systems Inc. v. Department of Environmental Quality, 511 U.S. 93 (1994).

11 Id.

12 OKLA. STAT. tit. 68, § 2358.D.2.a.

13 Hughes v. Oklahoma, 441 U.S. 322 (1979).

14 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.

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